OF  THE 


University  of  California. 


Class 


Digitized  by  the  Internet  Archive 

in  2007  with  funding  from 

IVIicrosoft  Corporation 


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AUDITING 


A  PRACTICAL  MANUAL 
FOR  AUDITORS 


By 

LAWRENCE  R.  DICKSEE,  M.Com.,  F.C.A. 

(of  the  firm  of  SeLlaRS,  DICKSEE  ca  CO.) 

Formerly  Professor  of  Accounting  at  the  University  of  Birmingham, 

cow  of  the  London  School  of  Economics  and  Political  Science  (University  of  London) 


Editedlby 

ROBERT  H.  MONTGOMERY,  C.P.A. 

(ofthc  firm  of  LYBRAND,  ROSS  BROS.  Ca.  MONTGOMERY) 
Attorney  at  Law 


AUTHORIZED  AMERICAN  EDHION 

Rel>ised  and  Enlarged 


^brIa 


OF   THE 

UNIVERSITY 

OF 

IFOKN^ 


RONALD  PRESS  CO. 
NEW  YORK 

1909 


Copyright,  1909 

by  Robert  H.  Montgomery 

All  Rights  Reserved. 


CONTENTS 


PAGE 

Statement  by  the  Author  of  the  English  Edition,   .      .  4 

Preface  to  the  American  Edition, 5 

Preface  to  the  Second  American  Edition, 8 

Introduction  by  A.  Lowes  Dickinson 11 

I. — Introduction,         17 

II. — Methods  of  Account, 55 

III. — Special  Considerations  in   Different  Classes  of 

Audits, 90 

IV. — The  Same  (Continued) 132 

V. — The  Same  (Continued), 158 

VI. — From  Trial  Balance*  to  Balance  Sheet,     ...  168 

VII. — Form  of  Accounts  and  Balance  Sheets,     .      .      .  208 

VIII. — What  are  Profits? 246 

IX. — The  Attitude  of  the  Auditor, 266 

X. — The  Liabilities  of  Auditors, 290 

XI. — Investigations, 315 

XII. — Interest, 342 

Appendix    A.     Legal     Liability      of      Auditors,      Legal 

Decisions,  &c., 356 

Appendix    B.     Professional  Ethics, 380 

Appendix    C.     American  Malting  Case, 386 

Appendix    D.     Forms  of  Accounts, 396 

Appendix    E.     C.  P.  A.  Examination  Questions,     ...  510 

Appendix    F.     Extract  from  "Tretyce  off  Housebandry,"  537 

Appendix    G.     United  States  Corporation  Tax  Law  of  1909  540 


202587 


AUTHORIZATION. 


To  avoid  misunderstanding  I  have  thought  it  desirable  to 
append  a  note  to][this  volume,  pointing  out  that  it  has  been 
issued  by  arrangement  with  me,  and  that  the  various  altera- 
tions and  amendments  that  have  been  effected,  with  a  view  to 
making  the  work  more^suitable  to  the  needs  of  American  prac- 
titioners and  accountant  students,  have  all  been  submitted  to 
me  and  have  met  with  my  entire  approval. 

The  numerous  extracts  from  Acts  of  Parliament  that  appear 
in  the  English  Edition  have  been  omitted,  and  the  somewhat 
voluminous  reports  of  British  legal  decisions  have  been  ma- 
terially condensed ;  but  the  alterations  in  the  body  of  the  work 
are  only  such  as  appeared  to  be  called  for  under  the  cir- 
cumstances, and  while  condensation  has  taken  place  in  some 
directions,  in  others  the  scope  of  the  work  has  been  con- 
siderably elaborated. 

I  trust  that  the  production  of  this  Americanized  Edition  of 
my  work  will  add  to  the  popularity  that  it  has  already  earned 
in  the  States  during  the  past  seventeen  years. 


LAWRENCE  R.  DICKSEE. 


CoPTHALL  House, 
London,  E.  C, 
England. 
24th  September,  1909. 


OF  THE 

UNIVERSITY 

OF 


PREFACE   TO   THE   AMERICAN   EDITION. 


It  cannot  be  expected  that  any  hard'and  fast  rules  will  ever 
prevail,  nor  is  it  desirable  that  the  personal  element  in  an 
audit  should  be  superseded  by  instruction  prepared  in  advance, 
but  Jt  must  be  admitted  that  the  experiences  of  one  profes- 
sional Auditor  are  of  great  value  to  others.  It  is  the  object  of 
this  work,  therefore,  to  state  as  concisely  as  possible,  the 
results  of  Mr.  Dicksee's  experience  supplemented  by  sugges- 
tions from  leading  English  and  American  accountants,  and  it 
is  believed  that  some  portion  of  this  book,  at  least,  will  be 
found  valuable  to  every  American  practitioner  and  student* 

Much  of  the  matter  herein  contained  is  taken  verbatim 
from  Mr.  Dicksee's  English  edition,  which  for  many  years 
has  been  the  standard  work  on  Auditing  both  in  Great  Britain 
and  America.  The  principal  changes,  therefore,  are  those 
which  are  cau  sed  by  the  numerous  differences  existing  between 
accountancy  nomenclature,  laws  and  customs  of  Great  Britain 
and  the  United  States. 

The  interchange  of  thought  which^^has  followed  the  various 
meetings  of  the  English  Societies,  and  which  has  been  of  great 
value  to  the  profession  at  large,  had  no  counterpart  in  the 
United  States  until  the  holding  in  September,  1904,  of  the 
Congress  of  Accountants  at  St.  Louis.  Discussion  of  the 
papers  read  on  various  accountancy  topics  did  much  to  em- 

5 


6  PREFACE    TO    THE    AMERICAN    EDITION. 

phasize  the  importance  of  a  better  understanding  among  ac- 
countants, particularly  along  the  lines  of  uniform  methods  of 
preparing  and  stating  accounts.  These  suggestions  covered 
not  only  municipal  and  public  service  corporation  accounts, 
but  embraced  general  methods  as  well. 

We  find  ourselves,  therefore,  at  the  very  threshold  of  what 
may  be  called  a  new  era  in  the  profession  in  the  United  States, 
and  we  are  fortunate  in  having  the  benefit  of  the  best  English 
practice  as  a  guide  to  our  broadened  field.  We  must  recog- 
nize, however,  the  wide  differences  between  our  laws  and  cus- 
toms, and,  while  the  essential  principles  underlying  all  prop- 
erly conducted  audits  are  the  same,  yet  it  may  be  found  here- 
after that  more  radical  modifications  in  Mr.  Dicksee's  text  will 
be  in  order. 

References  made  herein  to  American  customs  are  based  on 
my  general  practice  and  observations  covering  a  number  of 
years,  but  no  claim  is  made,  of  course,  that  the  field  has  been 
sufficiently  covered  to  warrant  the  statement  that  the  last 
word  has  been  said  on  any  subject  of  which  mention  is  made. 
On  the  contrary,  it  can  only  be  hoped  that  the  necessity  for  a 
somewhat  better  understanding  as  to  "good  practice"  than 
has  heretofore  existed  will  be  recognized. 

I  take  this  opportunity  to  express  my  indebtedness  to 
several  members  of  the  profession  for  valuable  suggestions 
received.  In  particular  I  desire  to  express  my  thanks  to 
Arthur  Lowes  Dickinson,  M.A.,  F.C.A.,  C.P.A.,  and  to  my 
partner,  William  M.  Lybrand,  C.P.A. 

As  a  fitting  conclusion,  nothing  better  expresses  my  thought 
than  the  last  clause  of  the  Preface  of  Mr.  Dicksee's  first 
English  Edition : — 


PREFACE    TO    THE    AMERICAN    EDITION.  7 

"As  I  have  no  claim  to  completeness  in  this  work,  so  also 
do  I  wish  to  disclaim  any  assumption  of  absolute  finality;  and, 
accordingly,  I  shall  consider  myself  greatly  indebted  to  my 
readers  for  any  suggestions  and  opinions  with  which  they  may 
be  pleased  to  favor  me,  which,  I  need  hardly  add,  shall  re- 
ceive every  attention  upon  the  publication  of  a  new  edition." 


ROBERT  H.  MONTGOMERY. 


43  Exchange  Place, 

New  York. 
2Sth  August,  1905. 


PREFACE    TO    THE    SECOND    AMERICAN 

EDITION. 


During  the  four  years  which  have  elapsed  since  the  publica- 
tion of  the  first  American  edition  of  this  work,  four  thousand 
two  hundred  and  fifty  (4250)  copies  have  been  printed. 

Its  reception  was  very  gratifying  and  it  is  to  be  hoped  that 
the  present  edition  will  be  received  as  kindly. 

The  entire  text  of  the  first  edition  has  been  revised,  but  no 
material  changes  have  been  made  in  the  general  principles 
which,  as  enunciated  by  Mr.  Dicksee  and  again  reprinted, 
represent  the  best  thought  of  the  profession  here  and  abroad. 

Within  a  few  years  there  has  been  a  considerable  advance 
with  respect  to  standard  forms  of  accounts  and  it  seemed 
wise  to  reproduce  a  number  of  them  in  this  volume. 

Other  new  matter  also  appears,  all  of  which  is  submitted 
with  the  hope  that  it  may  prove  of  interest  to  members  of 
the  profession  and  of  practical  assistance  to  students. 

I  am  indebted  to  Walter  A.  Staub,  C.  P.  A.,  for  his  services 
in  connection  with  this  edition,  particularly  with  reference 

8 


PREFACE    TO    THE    SECOND    AMERICAN    EDITION.  9 

to  the  chapter  on  Interest  and  the  Discussion  of  the  Corpora- 
tion' Tax  Law. 

I  wish  to  repeat  the  statement  which  will  be  found  in  the 
preface  to  my  first  edition,  viz.:  "I  shall  consider  myself 
greatly  indebted  to  my  readers  for  any  suggestions  and 
opinions  with  which  they  may  be  pleased  to  favor  me." 

ROBERT  H.  MONTGOMERY. 

165  Broadway, 

New  York. 
2d  December,  1909. 


OF  THE 

UNIVERSITY 

OF 


INTRODUCTION. 


BY    ARTHUR    LOWES    DICKINSON,    M.A.,    F.C.A.,    C.P.A. 

The  publication  of  an  American  edition  of  Mr.  L.  R. 
Dicksee's  work  on  Auditing  is  further  evidence  of  the  grow- 
ing importance  to  the  community  of  a  correct  understanding 
of  the  principles  of  Accounting;  and  the  fact  that  this  edition 
has  received  the  support  of  educational  authorities  throughout 
the  country  is  full  of  promise  for  the  future  of  the  still  young 
profession  of  the  Public  Accountant. 

Bookkeeping  is  a  simple  science,  and  complete  mastery  of 
its  principles  does  not  call  for  any  very  high  order  either  of 
intelligence  or  of  education.  Bookkeeping,  however,  is  only 
one,  and  perhaps  the  smallest,  of  the  necessary  qualifications 
for  the  Public  Accountant  who  would  succeed  in  his  profession. 

The  question  is  daily  asked — What  is  a  Public  Accountant  ? 
And  the  answer  that  best  defines  his  place  in  the  world  of 
Commerce  may,  perhaps,  be  expressed  as  follows:  A  Public 
Accountant  is  a  person  skilled  in  the  affairs  of  Commerce  and 
Finance,  and  particularly  in  the  accounts  relating  thereto, 
who  places  his  services  at  the  disposal  of  the  community  for 
remuneration.  This  definition  calls  for  three  main  qualifica- 
tions : — 

(i)  Skill  in  the  affairs  of  Commerce  and  Finance. 

(2)  Special  skill  in  the  Accounts  relating  thereto. 

(3)  The  application  of  this  skill  to  the  affairs  of  the  com- 

munity, and  not  merely  of  one  Corporation  or  Firm, 
for  remuneration. 

II 


12  INTRODUCTION. 

In  Great  Britain  the  Public  Accountant  has  during  the  past 
quarter  of  a  century  worked  out  his  own  salvation,  and  is 
regarded  as  a  skilled  Commercial  and  Financial  Advisor,  not 
only  on  accounts,  but  upon  general  business  matters.  While 
he  is^frequently  appointed  to  such  positions  of  Trust  as  Liqui- 
dator, Receiver,  &c.,  which  in  this  country  are  either  awarded 
for  political  reasons  or  to  Lawyers,  his  main  duties  consist  in 
the  audit  of  the  accounts  of  Corporations,  Firms  and  Indi- 
viduals, and  it  is  to  this  branch  of  the  subject  that  the  present 
volume  mainly  relates. 

The  Public  Accountant  acting  as  a  Professional  Auditor 
must  be  familiar  with  the  general  principles  of  Commercial 
and  Common  Law,  including  that  relating  to  Corporations, 
Bankruptcy  and  Trusts;  he  must  be  acquainted  with  Econo- 
mic and  Banking  principles;  and  with  those  underlying  the 
valuations  of  property  of  all  kinds.  But  his  knowledge  of  all 
these  subjects  is  a  means  to  an  end,  and  that  end  is  the  applica- 
tion thereof  to  that  one  subject  of  Accounts  in  which  his  skill 
specially  lies ;  while  on  the  more  complicated  Legal,  Economic 
or  Valuation  questions  he  must,  and  does,  consult  those  other 
business  Advisors  who  have  special  skill  in  these  matters. 
There  is  probably  no  other  profession,  not  even  excepting 
that  of  Law,  which  requires  of  its  members,  if  they  would  suc- 
ceed, a  higher  standard  of  education,  experience  and  general 
business  knowledge. 

Within  recent  years  the  degree  of  Certified  Public  Account- 
ant has  been  created  by  certain  States.  The  future  value  to 
the  Profession  of  this  degree  is  exactly  what  its  members  make 
it,  and  no  more.  The  holders  are  placed  in  a  privileged 
position,  which  is  of  value  only  so  far  as  by  their  own  honesty 
and  ability  they  can  maintain  a  standard  superior  to  those 
who  have  not  so  qualified.  The  future  is  with  the  rising 
generation,  and  the  various  Schools  of  Commerce  connected 
with  Universities  all  over  the  country  are  doing  excellent 
work  in  the  provision  of  educational  facilities.  As  the 
educational  standard  is  raised,  as  the  class  of  college  men  from 


IXTRODUCTIOX.  1$ 

whom  the  legal  profession  is  at  present  so  largely  recruited 
is  attracted  to  the  profession  of  Public  Accountant,  so  will 
the  standard  be  raised  to  a  yet  higher  level,  and  the  profession 
will  gradually  obtain  that  full  and  complete  recognition 
already  obtained  in  England,  but  as  yet  very  grudgingly  and 
•only  to  a  small  degree  accorded  in  America. 

The  moral  qualities  called  for  are  so  high  that  it  should 
place  the  profession  at  the  head  of  all  which  come  into  contact 
with  business  affairs.  The  Lawyer's  duty  is  first  of  all  to  his 
client,  and  that  duty  frequently  compels  him  to  avail  himself 
of  technicalities  and  other  means  of  enabling  that  client  to 
evade  the  Law  and  its  penalties;  but  the  Public  Accountant 
has  only  one  duty  to  his  client  and  to  the  Public,  and  that  is  to 
disclose  to  him  or  for  him  "the  truth,  the  whole  truth,  and 
nothing  but  the  truth,"  so  far  as  his  abilities  and  special  train- 
ing to  that  end  enable  him  to  ascertain  it.  No  legal  quibbles 
will  save  him  from  moral  condemnation  if  he  fails  in  this 
duty;  no  juggling  with  words  and  phrases  will  absolve  him 
from  responsibility,  moral  and  often  legal,  for  results  which 
he  has  reason  to  know  are  not  what  they  seem  to  be,  or  which, 
having  regard  to  his  special  training  in  business  affairs  and 
the  accounts  relating  thereto,  he  ought  to  have  known  did  not 
represent  the  facts.  Errors  there  may  be  and  must  be  and 
for  errors  made  after  full  and  proper  precaution  taken  and 
due  care  exercised  no  responsibility  will  lie.  But  there  is  no 
profession  in  which  the  results  of  careless  errors  or  misstate- 
ments will  more  certainly  bring  retribution. 

While  differences  of  opinion  on  matters  of  principle  must 
always  exist,  perhaps  they  exist  to  a  less  extent  in  Account- 
ancy for  the  reason  that  most  of  its  problems  when  attacked 
with  intelligence  admit  of  being  carried  back  to  elementary 
first  principles.  The  faculties  requisite  for  such  a  mental 
exercise  are  the  result  of  thorough  training  and  long  experience 
coupled  with  a  mind  naturally  gifted  with  analytic  powers; 
and  having  regard  to  the  variety  of  problems  which  arise,  the 
first  principles  or  admitted  facts  necessary  to  their  solution  are 


14  INTRODUCTION. 

themselves  very  numerous.  The  best  preliminary  training 
would  seem  to  consist  in  the  acquirement  of  a  thorough  knowl- 
edge of  these  principles  or  facts  throughout  the  domain  of 
Mathematics,  Economics,  Banking,  Law  and  Commerce;  the 
practical  application  of  these  principles  to  the  special  science 
of  Accounting  naturally  follows,  and  the  present  volume  may 
be  described  as  an  elementary  text-book  on  the  practical  side 
of  the  question.  If  the  student  would  avail  himself  thoroughly 
of  it,  he  must  analyze  every  proposition  therein  to  its  elements, 
search  out  the  economic,  legal  or  commercial  reasons  for  it, 
and  so  fit  himself  to  pass  judgment  upon  the  actual  facts  which 
may  come  before  him  in  his  wider  practice  in  the  Commercial 
world. 

The  Public  Accountant  so  trained  who  will  apply  his  whole 
mental  energies  to  the  problems  before  him,  and  arrive  at  a 
solution  unbiased  by  any  outside  influence, and  confident  in  his 
own  ability,  and  above  all  integrity,  need  have  little  fear  of 
the  pains  and  penalties  described  in  the  Chapter  on  the  Audi- 
tor's  responsibility. 


AUDITING. 


CHAPTER  I. 


INTRODUCTORY. 

AUDITING  (up  to  the  Trial  Balance). 


PRELIMINARY  CONSIDERATIONS. 

Before  touching  on  matters  of  detail  it  may  be  well  to  ob- 
serve that  the  sole  purpose  of  this  book  is  to  treat  of  an  audit 
from  the  standpoint  of  the  professional  auditor  and  the  student 
who  have  mastered  the  principles  of  bookkeeping,  and  it  is, 
therefore,  not  deemed  necessary  to  discuss  nor  define  "Audit- 
ing'* in  the  abstract. 

It  is  obvious,  too,  that  the  preliminary  stages  of  arranging 
for  the  work,  settling  upon  its  scope,  and  the  general  attitude 
of  the  auditor  are  all  matters  which  appear  for  examination 
more  logically  in  later  chapters. 

For  some  years  it  has  been  the  custom  of  leading  firms  of 
accountants,  both  in  England  and  America,  to  use  a  small 
note  book  for  each  audit  on  which  they  are  engaged. 

The  form  usually  preferred  consists  of  a  book  with  printed 
instructions  of  a  general  nature  in  front,  followed  by  several 
blank  pages  for  special  instructions  applicable  to  the  particular 
audit,  and  for  memoranda  to  be  written  up  during  successive 
audits. 

Specially  ruled  pages  are  then  provided.  Each  page  is  used 
to  record  the  work  done  on  one  book  or  class  of  accounts,  and 
enough  sheets  should  be  bound  in  each  book  to  allow  for 
recording  the  memoranda  of  the  audit  of  a  large  undertaking. 
The  pages  are  printed  and  ruled  somewhat  as  follows: 

17. 


18 

AUDITING. 

> 

> 

< 

M 

M 
M 

o 

o 

O 

M 

> 



M 

,,     >^    ... 

< 
w 

1 

§ 

G 

1 

i 

u 

1 
1 

1 

1 

1 
i 

> 

s 

a 

1 
1 

12 

1 

1 

1 

1 

42 

1 

5 

1 

AUDITING    (up  to  THE  TRIAL  BALANCE).  IQ 

The  most  convenient  book  is  one  in  which  each  page  is 
ruled  with  twelve  double  columns,  thus  providing  for  the 
record  of  a  year's  work  where  the  audits  are  made  monthly, 
six  years'  work  where  they  are  made  semi-annually,  etc.  The 
columns  are  arranged  so  that  the  date  of  completing  each 
part  of  the  work  may  be  recorded  as  well  as  the  initials  of 
the  audit  clerk. 

Since  the  issue  of  the  first  American  edition  of  this  work,  the 
Accountancy  Publishing  Co.  has  published  an  "  Audit  Note- 
Book,"  the  demand  for  which  is  sufficient  to  prove  that  the 
use  of  such  a  book  is  very  general  among  the  profession. 

On  the  other  hand,  it  has  been  suggested  "  that  if  a  com- 
petent clerk  is  sent  to  undertake  an  audit  (and  none  but  com- 
petent clerks  should  be  sent),  it  is  much  the  better  way  to 
leave  him  unfettered  with  printed  instructions,  but  allow  him 
to  go  thoroughly  into  the  whole  system  in  operation,  and  from 
the  nature  of  such  system,  and  from  what  he  sees,  let  him 
outline  his  own  method  of  procedure.  By  this  means  there  is 
not  so  much  danger  of  his  getting  into  a  semi-careless  groove 
of  working,  and,  moreover,  he  feels  that  more  responsibility 
is  placed  upon  him,  which  acts  as  an  incentive  to  do  the  work 
more  thoroughly  than  would  be  the  case  were  he  working  to 
*  rule  of  thumb.' "  There  is,  doubtless,  something  to  be  said 
upon  this  side  of  the  question;  but  if  so  much  be  left  to  the 
clerk,  it  is  a  little  difficult  to  see  what  the  principal  is  expected 
to  do  himself.  In  any  case,  however,  the  book  is  useful  as  a 
record  of  the  routine  work  performed  and  of  the  queries  raised 
in  the  course  of  audit.  It  is  believed  that,  in  point  of  fact, 
some  sort  of  audit  note-book  is  almost  invariably  used  by 
most  accountants  at  the  present  time. 

The  printed  instructions  cannot  be  more  than  a  mere  out- 
line of  an  auditor's  duties,  but  they  can  be  so  framed  as  to 
be  of  material  assistance  to  the  audit  clerks. 

The  following  instructions  are  modelled  after  a  set  used  in 
an  English  office  for  many  years,  and  will  be  found  extremely 


20  AUDITING. 

suggestive.  Various  modifications  of  these  instructions  appear 
in  most  audit  note-books.  It  is  understood,  of  course,  that  no 
attempt  is  made  to  lay  down  any  hard  and  fast  rules. 

INSTRUCTIONS    FOR   AUDIT. 

1.  In  commencing  a  new  audit  obtain  a  list  of  all  the  books  kept,  and 
of  all  persons  authorized  to  receive  or  pay  money  and  order  goods. 

2.  In  the  case  of  a  corporation,  examine  the  by-laws  and  board 
minutes  respecting  the  receipt  and  payment  of  money,  and  the  drawing 
of  cheques,  notes,  &c. 

3.  Ascertain  and  take  note  of  the  general  system  upon  which  the 
books  are  constructed,  and  the  plan  of  checking  the  correctness  of 
the  accounts  paid,  and  whether  they  are  paid  exclusively  or  generally 
by  cheques. 

4.  Report  if  the  accounts  and  vouchers  have  been  systematically 
checked  and  certified;  and  note  any  discrepancies. 

5.  Compare  the  cancelled  cheques  with  the  cash  payments.  Compare 
a  portion  of  the  items  of  deposits,  as  detailed  in  cheque  stubs  or  copy- 
book, with  the  receipt  side  of  the  cash  book,  to  determine  whether  all 
items  deposited  have  been  properly  entered.  Prove  the  reconciliation 
of  the  cheque  book  balances  at  the  end  of  the  period  with  the  bank  pass 
books,  and  see  that  the  latter  are  frequently  balanced  and  examined. 

6.  Note  any  unusual  or  extraordinary  payments  or  receipts. 

7.  In  regard  to  the  payments  for  wages  and  petty  cash,  note  any 
unusual  items,  and  see  that  vouchers  for  all  other  payments  are  kept 
and  produced. 

8.  In  all  cases  where  branch  establishments  are  included  in  one 
business,  you  will  be  careful  to  examine  into  the  mode  of  bringing  the 
returns  of  operations,  accounts,  and  expenses  to  the  head  office. 

9.  Examine  the  purchase  and  sales  books,  and  see  that  the  proper 
returns  of  purchases  and  sales  are  made  by  each  department;  that  the 
purchase  and  sales  books  are  properly  entered  up;  that  the  invoices 
are  properly  checked  as  to  quantities  and  prices;  satisfy  yourself  that 
every  liability  of  the  year  is  brought  into  the  accounts. 

10.  Ask  for  special  instructions  as  to  how  far  the  postings  and  foot- 
ings of  the  individual  ledgers  and  the  footings  of  the  books  of  original 
entry  are  to  be  verified. 

11.  All  the  postings  in  the  nominal  or  general  ledgers  must  be 
checked.  The  mode  of  the  journalizing  must  be  carefully  examined 
and  its  correctness  tested. 


AUDITING    (up  to  THE  TRIAL  BALANCE).  21 

12.  Verify  the  trial  balances  of  all  ledgers,  being  careful  not  to  omit 
the  comparison  of  the  totals  of  those  of  subsidiary  ledgers  with  the 
controlling  accounts  in  the  general  ledger  trial  balance. 

13.  Examine  the  bills  receivable  and  bills  payable  books,  and  note 
any  item  of  past  due,  renewed  or  protested  notes,  and  make  list  of 
same  and  of  the  collateral  security,  if  any. 

14.  Examine  the  entries  and  transfers  passed  through  the  journal, 
and  check  the  postings;  and  although  you  are  not  held  responsible  for 
the  details  of  classification,  it  is  desirable  you  should  make  any  sug- 
gestions  required,  and  note  any  discrepancies,  especially  in  relation  to 
the  division  thereof  on  account  of  capital  and  revenue  accounts 
respectively. 

15.  Ask  for  special  instructions  as  to  examination  of  capital  stock 
and  mortgage  bond  accounts. 

16.  In  the  accounts  of  stock-taking  see  that  all  stock  sheets  and 
returns  are  duly  signed  by  the  heads  of  departments,  and  that  the  same 
are  correctly  carried  forward  to  the  general  inventory  account;  and 
ascertain  and  note  whether  goods  finished  or  in  progress  are  taken  at 
cost  price  or  otherwise;  also  in  large  concerns  report  whether  an 
independent  clerk  has  verified  the  stock  returns  in  regard  to  prices 
and  quantities. 

17.  In  checking  the  profit  and  loss  account,  note  whether  the  usual 
and  proper  deductions  have  been  made  for  wear  and  tear  and 
depreciation. 

18.  Take  care  that  in  the  balance  sheet  no  additions  are  made  to 
expenditure  on  capital  account,  except  such  as  are  authorized  or 
passed  upon  by  some  responsible  person,  and  note  the  distinction  be- 
tween new  works  and  mere  replacements. 

19.  Ascertain  the  correctness  of  the  cash  balances,  promissory  notes, 
and  other  securities  in  hand.  Take  note  of  any  items  or  memoranda 
carried  as  cash. 

To  sum  up,  then,  the  matter  may  be  stated  thus: — At  the 
commencement  of  an  audit  the  principal  should  if  possible,  go 
over  the  ground  personally,  and  decide  what  w^ork  requires 
to  be  done.  A  list  of  such  work  (together  with  any  other 
special  notes  that  may  seem  desirable)  should  be  entered  in 
the  audit  note-book,  which  should  be  ruled  in  columns,  so 
that  the  initials  of  a  clerk  against  any  item  may  clearly  show 
that  he  is  responsible  for  the  correctness  of  that  item  for  the 


22  AUDITING. 

period  named  at  the  head  of  the  column.  As  heretofore 
mentioned,  it  is  practicable  to  keep  books  ready  printed  which, 
with  but  slight  alteration,  will  answer  the  purposes  of  any 
audit;  but  there  will  usually  be  some  special  circumstances 
connected  with  each  audit  that  distinguish  it  from  others,  and 
these  circumstances  will  usually  involve  some  modification  of 
the  customary  routine  obtaining  to  that  class  of  accounts. 

Some  sort  of  definite  system  is  undoubtedly  preferable  to 
leaving  things  too  much  in  the  hands  of  the  audit  clerk,  as 
there  is,  in  the  latter  case,  always  a  danger,  either  of  dis- 
satisfying the  client,  or  else  of  leading  him  to  prefer  a  change 
of  principals  to  a  change  of  clerks,  if  one  of  the  two  be  in- 
evitable. For  this  reason,  if  for  no  other,  the  principal 
should  always  endeavor  to  keep  the  reins  of  every  audit  in 
his  own  hands,  or,  at  least,  out  of  the  exclusive  control  of  any 
one  audit  clerk;  for,  although  objection  may  legitimately  be 
taken  to  the  latter  being  kept  at  a  continual  game  of  "  General 
Post,"  it  cannot  be  denied  that  it  is  a  mistake  to  invariably 
send  the  same  clerks  to  the  same  audits. 

THE    OBJECT    AND    SCOPE    OF    AN    AUDIT. 

The  next  point  to  be  considered  is  the  object  and  extent  of 
an  audit.     The  object  of  an  audit  may  be  said  to  be  threefold: 

(i)  THE  DETECTION  OF  FRAUD. 

(2)  THE  DETECTION  OF  TECHNICAL  ERRORS. 

(3)  THE  DETECTION  OF  ERRORS   OF   PRINCI- 
PLE. 

On  account  of  its  intrinsic  importance  the  detection  of  fraud 
is  clearly  entitled  to  be  considered  an  "  object "  in  itself,  al- 
though it  will  be  obvious  that  it  can  only  be  concealed  by  the 
commission  of  a  technical  error  or  of  an  error  of  principle. 
It  will  be  appropriate,  therefore,  to  combine  the  search  after 
fraud  with  search  for  technical  and  fundamental  errors;  but 
it  can  never  be  too  strongly  insisted  that  the  auditor  may  find 
fraud  concealed  under  any  item  that  he  is  called  upon  to  verify. 


AUDITING    (up  to  THE  TRIAL  BALANCE).  23 

His  research  for  fraud  should  therefore  be  unwearying  and 
constant. 

It  has  been  asserted  by  some  that  the  whole  duty  of  the 
auditor  is  to  ascertain  the  exact  state  of  his  client's  affairs 
upon  a  certain  given  date.  This  is,  in  effect,  the  same  thing 
as  saying  that  he  is  only  responsible  for  the  correctness  of 
the  balance  sheet.  Even  if  this  be  the  case — and  it  is  open 
to  considerable  doubt,  as  the  extent  of  an  auditor's  duties  de- 
pends entirely  upon  the  terms  of  the  express  or  implied  con- 
tract between  himself  and  his  client — the  balance  sheet  cannot 
well  be  verified  without  a  proper  examination  of  the  revenue 
account,  which  in  its  turn  involves  a  complete  examination  of 
the  books. 

The  detection  of  fraud  is  a  most  important  portion  of  the 
auditor's  duties,  and  there  will  be  no  disputing  the  contention 
that  the  auditor  who  is  able  to  detect  fraud  is — other  things 
being  equal — a  better  man  than  the  auditor  who  cannot. 
Auditors  should,  therefore,  assiduously  cultivate  this  branch 
of  their  functions — doubtless  the  opportunity  will  not  for  long 
be  wanting — as  it  is  undoubtedly  a  branch  that  their  clients  will 
most  generally  appreciate. 

Before  dealing  with  the  various  methods  to  be  adopted  to 
insure  the  detection  of  errors,  it  will  perhaps  be  not  out  of 
place  to  inquire  what  is  the  extent  to  which  an  auditor  is  ex- 
pected to  carry  his  research.  This  will  naturally  vary  accord- 
ing to  the  circumstances  of  each  individual  case ;  but  even 
allowing  for  this,  the  greatest  diversity  of  opinion  obtains,  some 
claiming  that  an  auditor's  duty  is  confined  to  a  comparison  of 
the  balance  sheet  with  the  books,  while  others  assert  that  it  is 
the  auditor's  duty  to  trace  every  transaction  back  to  its  first 
source.  Between  these  two  extremes  every  shade  of  opinion 
may  be  found;  and,  among  others,  the  opinion  of  most  prac- 
tical men.  Were  the  auditor's  functions  limited  to  a  certifica- 
tion that  the  balance  sheet  submitted  to  him  was  in  accordance 
with  the  books,   it  would  be  difficult  to  conceive  why   the 


24  AUDITING. 

amateur  auditor  should  have  been  found  so  lamentably  want- 
ing: on  the  other  hand,  it  cannot  be  denied  that  (except  in 
concerns  of  comparative  insignificance)  a  minute  scrutiny  of 
every  item  would  be  quite  impossible  to  the  auditor — nor  in- 
deed is  such  a  detailed  audit  often  necessary,  although  it  is  in 
the  highest  degree  desirable  that  every  undertaking  should 
possess  the  means  of  enabling  the  staff  to  make  such  an  exam- 
ination for  itself. 

In  undertakings  where  the  transactions  are  too  numerous 
to  justify  checking  every  entry,  it  is  usually  possible  to  test 
the  accuracy  of  the  bulk  of  the  work  by  aggregates  which 
appear  in  subsidiary  books  and  ledgers,  and  which  are  repre- 
sented in  the  general  or  private  ledger  by  controlling  accounts. 

This  is  a  matter  that  will  be  dealt  with  at  some  length  later 
on,  and  its  further  consideration  may  be  postponed  until  that 
time. 

It  is  in  the  highest  degree  necessary  that  the  auditor,  before 
commencing  his  investigation,  should  thoroughly  acquaint  him- 
self with  the  general  system  upon  which  the  books  have  been 
kept. 

In  England  it  is  customary  in  most  cases,  and  compulsory 
in  others,  for  the  auditor  to  be  supplied  with  a  list  of  the 
books  in  use,  but  in  this  country  the  list  is  in  nearly  all  cases 
either  not  supplied  at  all  or  else  it  is  made  by  the  auditor 
himself  during  the  progress  of  the  audit.  Such  a  practice  is, 
indeed,  very  desirable.  It  cannot  be  too  strongly  insisted,  how- 
ever, that  such  a  list  can  only  be  of  any  real  utility  when  the 
auditor  thoroughly  grasps  the  uses,  and  the  possible  abuses, 
of  which  each  book  is  capable.  Numerous  instances  have 
been  known  of  an  audit  entirely  failing' through  neglect  of  this 
precaution. 

Having  thoroughly  made  himself  master  of  the  system,  the 
auditor  should  look  for  its  weakest  points.  "  Where  is  fraud 
most  likely  to  creep  in  ?  '*  he  should  ask  himself ;  and,  if  he 


AUDITING    (up  to  THE  TRIAL  BALANCE).  25 

can  find  a  loop-hole,  let  him  be  doubly  vigilant  there.  But 
never  let  him  for  a  moment  suppose  that,  because  he  sees  no 
opportunity  for  fraud,  none  can  exist.  To  the  intelligent 
auditor  who  has  grasped  his  system  thoroughly,  it  is  gen- 
erally practicable  to  dispense  with  a  considerable  portion  of  the 
mechanical  means  of  checking.  To  what  extent  this  can  be 
done  with  safety  must  always  remain  a  question  for  each 
auditor's  own  intelligence  and  experience  to  answer,  and  it 
may  be  added  that  probably  he  must  take  the  risk  of  any  conse- 
quences that  may  ensue;  but — so  far  as  the  matter  can  be 
explained  in  a  general  treatise — its  solution  will  be  sought  after 
in  these  pages. 

Before  leaving  this  subject,  it  may,  perhaps,  be  well  to  add 
that,  under  the  expression  "  mastery  of  the  general  system," 
perusal  of  the  partnership  agreement,  the  charter  and  by-laws 
of  a  corporation,  recorded  contracts  and  agreements,  State 
laws,  and  any  and  all  other  documents  that,  per  se,  affect  the 
general  constitution  of  the  concern,  are  included. 

ADVANTAGES    OF    AN    AUDIT. 

The  question  has  been  raised  from  time  to  time  as  to  what 
advantages  may  be  reasonably  expected  from  a  proper  profes- 
sional audit  of  accounts.  In  addition  to  those  mentioned, 
as  coming  under  the  head  of  the  primary  objects  of  auditing, 
it  may  be  pointed  out  that  the  proprietor  or  proprietors  of  a 
business  will  not  only  have  the  advantages  of  having  placed 
before  them  an  accurate  statement  of  their  affairs,  together 
with  a  profit  and  loss  account  showing  how  this  position  has 
been  arrived  at,  but  that  they  would  also  have  available  certified 
accounts  as  to  profits  which  cannot  fail  to  be  of  the  greatest 
convenience,  in  the  event  of  their  wishing  to  sell  the  business 
to  a  private  trader,  or  firm,  or  to  an  incorporated  company, 
or  in  the  event  of  one  of  the  partners  dying  or  wishing  to 
retire,  or  for  the  purpose  of  submitting  a  statement  to  banks 
as  a  basis  for  loans.  One  of  our  most  eminent  New  York 
bankers  in  an  address  to  a  bankers'  convention  advised  those 


26  AUDITING. 

present  to  require  prospective  borrowers  to  furnish  statements 
prepared  by  Certified  Public  Accountants,  and  at  the  conven- 
tion of  the  American  Bankers'  Association,  held  at  Denver, 
Colorado,  in  the  autumn  of  1908,  the  Committee  on  Credit 
Information  reported,  urging  "  that  every  member  exert  his 
influence  to  have  all  paper  purchased  from  note  brokers  pre- 
sented with  accompanying  statements  audited  by  Certified  Pub- 
lic Accountants  .  .  ."  and  to  that  end  asked  that  the  Asso- 
ciation, by  the  adoption  of  the  Committee's  report,  "  recom- 
mend that  its  members  in  purchasing  commercial  paper  from 
note  brokers,  give  preference  to  such  names  as  furnish  accom- 
panying statements  audited  by  Certified  Public  Accountants. 
.  .  .  "  Under  each  of  these  circumstances  the  importance 
of  a  thoroughly  reliable  statement  of  profits  cannot  well  be 
over-estimated,  and  the  convenience  it  affords — as  well  as  the 
enhanced  price  which  can  be  obtained  in  the  event  of  a  sale — 
will  under  all  normal  circumstances  more  than  compensate  for 
any  slight  expense  which  the  audit  may  have  originally  in- 
volved. It  is,  of  course,  quite  clear  that  one  of  the  reasons 
an  enhanced  price  may  be  obtained  is  that  in  considering  an 
ordinary  statement  of  profits,  no  matter  how  carefully  it  may 
be  prepared  it  is  usual  to  "  discount "  the  results,  while  an 
audited  statement  can  be  safely  taken  at  its  face.  So  far  as 
private  firms  are  concerned,  an  efficient  audit  possesses  the 
further  advantage  that,  by  reason  of  its  insuring  a  periodical 
preparation  of  reliable  accounts,  it  tends  to  minimize  the  risk 
of  partnership  disputes,  with  all  their  attendant  annoyance 
and  expense.  Accurate  accounts  are  also  of  great  value  to  both 
sides  in  compensation  cases. 

In  the  case  of  corporations  the  audit  assumes  a  slightly 
different  aspect.  The  company  auditor  is  not  expected  to  act 
as  the  financial  adviser  of  the  undertaking — a  position  that  is 
frequently  thrust  upon  him  in  connection  with  private  audits — 
his  duty  being  rather  that  of  an  auditor  appointed  in  the  inter- 
ests of  an  inactive  partner.  It  devolves  upon  him  to  examine 
the  accounts  of  their  stewardship,  prepared  by  the  active  part- 


AUDITING    (up  to  THE  TRIAL  BALANCE).  27 

ner — i.  e.,  the  directors — and  to  state  whether  in  his  opinion 
those  accounts  are  correct,  and  fully  and  fairly  disclose  the 
position  of  affairs,  or  in  what  respects  they  fail  to  do  so. 

In  addition,  it  may  be  pointed  out  that  an  auditor,  through 
gross  negligence,  failing  to  discover  fraud  or  embezzlement 
on  the  part  of  the  employees  of  the  client,  may  possibly  be 
held  liable  in  damages  for  the  amount  lost  as  a  result  of  his 
negligence.  While  no  cases  bearing  on  the  specific  liability 
of  auditors  have  been  decided  by  any  of  the  higher  courts 
in  the  United  States,  the  law  is  very  well  settled  in  England 
that  auditors  are  liable  for  gross  negligence.  The  leading 
English  cases  are  cited  in  Appendix  A  to  this  work,  and  in 
the  absence  of  American  decisions  our  courts  can  be  expected 
to  follow  them.  If  they  do  not,  however,  they  will  seek 
analogous  cases  on  our  own  books,  and,  as  will  be  more  fully 
explained  in  a  later  chapter,  our  courts  are  reasonably  sure 
to  hold  auditors  strictly  accountable. 

This  liability  involves,  of  course,  a  corresponding  benefit  to 
the  persons  in  whose  favor  the  liability  accrues,  and  is  conse- 
quently a  factor  that  ought  not  to  be  lost  sight  of  in  weighing 
the  advantages  of  an  audit.  It  is,  however,  hardly  necessary 
to  add  that  the  auditor  does  not  insure  the  honesty  of  his 
clients'  employees. 

There  does  not  seem  to  be  any  general  realization  on  the 
part  of  many  auditors  of  the  responsibilities  they  assume  when 
they  undertake  to  audit  the  accounts  of  large  concerns  for  an 
extremely  small  fee — frequently  fixed  in  advance — and  which 
on  its  face  does  not  allow  for  more  than  a  mere  skimming  of 
the  aflFairs  of  the  company.  It  would,  therefore,  be  no  great 
calamity  to  the  profession  as  a  whole  to  have  an  American 
decision  definitely  settling  this  vexatious  question. 

Needless  to  say,  there  is  no  desire  on  the  part  of  any  Ameri- 
can practitioner  to  be  the  first  victim,  and  it  is  hoped  that 
with  a  more  general  knowledge  of  the  full  duties  and  respon- 


28  AUDITING. 

sibilities  of  professional  auditors  the  standard  will  be  raised 
to  a  point  where  no  severe  consequences  can  follow. 

METHOD    OF    AUDIT. 

A  comparison  of  the  relative  merits  and  disadvantages  of 
completed  and  continuous  audits  is  worthy  of  more  attention 
than  it  has  hitherto  attracted. 

THE  CONTINUOUS  AUDIT  sometimes  includes  the 
preparation  of  the  periodical  accounts  by  the  auditor's  staif. 
Its  advantages  may  be  said  to  be :  ( i )  The  examination  occurs 
sooner,  and  consequently  any  errors  committed  are  more 
quickly  detected  and  rectified;  (2)  the  periodical  visits  of  the 
auditor  keep  the  bookkeeper  closer  up  to  his  work;  (3)  a  more 
detailed  audit  is  practicable;  (4)  the  audit  can  be  completed 
soon  after  the  closing  of  the  books,  without  unduly  hurrying 
the  examination.  On  the  other  hand,  there  is  always  a  danger 
of  items  that  have  been  checked  by  the  auditor  being  altered 
(either  ignorantly  or  fraudulently)  before  the  final  audit;  and 
it  is  therefore  necessary  that  the  clerk  in  charge  of  a  continu- 
ous audit  be  very  wide  awake,  and  have  a  very  clear  idea  of 
the  system  under  which  he  is  working. 

It  has  been  found  a  good  plan  to  adopt  a  special  "  tick  " 
for  the  verification  of  all  figures  upon  which  a  correction  ap- 
pears; as,  if  this  plan  is  adopted,  a  correction  made  after  the 
tick  has  been  affixed  will  be  more  readily  discovered.  It  goes 
without  saying  that  the  difference  in  the  two  ticks  should  be 
as  slight  as  possible,  and  the  bookkeeper  should  not  be  told 
what  the  difference  implies. 

THE  COMPLETED  AUDIT  (by  which  is  meant  the  audit 
begun  after  the  trial  balance  has  been  completed)  obviates  this 
difficulty  to  a  certain  extent,  and,  if  the  books  remain  in  the 
auditor's  sole  custody  during  the  duration  of  the  audit,  entirely ; 
but  the  drawbacks  it  presents  (which  are,  naturally,  the  advan- 
tages of  the  continuous  audit)  render  its  adoption  impractica- 
ble, except  in  small  concerns  or  in  partial  audits,  unless  the 


AUDITING    (up  to  THE  TRIAL  BALANCE).  2g 

books  can  be  so  arranged  that  very  little  detailed  checking  has 
to  be  done  by  the  auditor. 

The  risks  involved  in  leaving  the  books  in  the  hands  of  the 
bookkeeper  during  the  audit  are  undoubtedly  very  consider- 
able; but,  so  long  as  these  difficulties  are  not  lost  sight  of, 
there  is  but  little  doubt  that  common-sense  and  a  general  alert- 
ness will  save  the  auditor  from  this — as  well  as  many  another 
— danger.  Moreover,  where  the  auditor  himself  closes  the 
books — and  this  will  not  infrequently  be  the  case  in  small  audits 
conducted  continuously — it  should  be  difficult  for  fraud  on  the 
part  of  the  staff  to  altogether  escape  detection. 

It  would  be  well  to  mention  here  the  extreme  importance  of 
completing  each  item  of  the  audit  as  soon  as  possible  after 
it  is  begun.  Extensive  frauds  have  escaped  detection  because 
the  auditor  checked  the  balances  of  a  ledger  one  day  and 
the  additions  of  such  balances  on  the  next — some  of  the  items 
having  been  altered  in  the  meantime.  It  will  be  obvious  that 
had  the  additions  been  checked  on  the  same  day  as  the  extrac- 
tion of  the  balances,  and  a  note  taken  of  the  total,  the  fraud 
would  have  been  impossible. 

What  may  be  described  as  the  "  ideal "  audit  is  one  com- 
bining the  two  modes  of  investigation  just  described.  It  is 
sometimes  attained  in  England  by  the  employment  of  two  in- 
dependent auditors,  one  performing  a  continuous  and  the  other 
a  completed  audit ;  but  more  frequently  the  continuous  audit  is 
done  by  "  staff  "  auditors,  or  by  the  client's  ordinary  employees 
under  a  good  system  of  internal  check. 

CALLING   BACK    POSTINGS. 

Having  now  cleared  the  ground  of  various  preliminary  con- 
siderations, the  manifold  points  arising  in  the  course  of  an 
ordinary  audit  will  be  dealt  with. 

It  has  been  seen  that,  in  every  instance,  it  will  be  necessary 
for  at  least  some  of  the  postings  to  be  called  over;  and  inas- 
much as  by  that  means  the  auditor  will  at  once  acquaint  him- 


30  AUDITING. 

self  with  the  nature  of  the  transactions  that  have  occurred, 
the  calling  back  of  such  postings  will  form  an  appropriate 
starting-point  for  examination.  Many  persons  prefer  to  start 
with  an  examination  of  the  vouchers,  and,  if  the  vouchers 
are  rich  in  detail,  it  will  frequently  be  desirable  to  take  them 
first;  but  when — as  is  often  the  case — they  are  mostly  bare 
receipts  for  so  much  money,  it  will  generally  be  best  to  start 
with  the  postings. 

It  is  well  to  commence  with  the  posting  of  the  cash  book, 
even  when  all  the  postings  are  to  be  checked,  as  by  this  means 
a  general  idea  of  the  business  done  is  most  quickly  grasped; 
which  is  very  desirable.  As  a  general  rule  the  postings  should 
be  called  back  from  the  ledger,  as  it  is  not  only  more  rapid 
as  a  rule,  but  in  cases  where  cash  credits  have  been  made  in 
the  ledger  without  a  corresponding  debit  to  cash  the  fraudu- 
lent entries  are  more  quickly  discovered.  The  calling  over 
of  postings  can  hardly  be  too  carefully  done,  and  although  the 
work  is  decidedly  mechanical — and,  consequently,  somewhat 
somniferous — it  must  be  most  conscientiously  performed.  In 
particular,  care  must  be  taken  not  to  pass  any  item  already 
ticked,  unless  it  be  certain  that  it  has  inadvertently  been  ticked 
in  the  regular  course  of  audit;  and  also  any  items  remaining 
unticked  after  the  calling  over  is  completed  should  receive  most 
careful  attention.  Inexperienced  clerks  are  apt  to  "  suppose  '* 
they  ought  to  have  ticked  an  item,  or  to  ''  suppose  "  they  ticked 
such-a-one  instead  of  such-another.  Either  "  supposition" 
may  cause  a  fraud  to  remain  undetected,  or  (which  will,  per- 
haps, appeal  to  the  youthful  mind  more  powerfully)  may  keep 
him  late  at  his  work  night  after  night,  while  the  senior  audit 
clerk  hunts  up  and  down  for  an  error  in  the  trial  balance. 
When  the  error  is  discovered  to  be  a  mistake  in  the  posting 
that  was  passed  in  calling  back,  it  is  possible  that  the  unfortu- 
nate junior  will  be  even  more  sorry  that  he  ever  ventured  to 
"  suppose." 

Where  it  is  intended  to  check  every  posting,  it  is  a  good 
plan,  after  the  cash  postings  have  been  checked,  for  the  remain- 


AUDITING    (up  to  THE  TRIAL  BALANCE).  3I 

ing  postings  to  be  called  back  from  the  ledger  into  the  jour- 
nals, etc. ;  and  it  will  probably  save  time,  while  going  through 
the  ledgers,  to  check  the  additions  and  balances  at  the  same 
time,  and  so  finish  each  ledger  at  a  sitting.  This  method,  how- 
ever, is  not  always  convenient,  or  even  possible,  and  much  must 
therefore  be  left  to  the  discretion  of  the  clerk  in  charge. 

Where  there  are  subsidiary  books  from  which  very  few 
postings  are  made  to  the  ledgers,  they  can  be  exhausted  before 
going  through  the  ledger  a  second  time  to  clean  up.  For 
instance,  with  a  journal  having  but  a  few  entries  the  first  item 
can  be  called  from  the  journal  to  the  ledger,  and  then  all  sub- 
sequent journal  entries  in  that  same  ledger  account  will  be 
called  back;  after  they  are  completed  the  second  item  in  the 
journal  should  be  taken  up,  and  so  on  until  the  journal  is 
exhausted. 

It  is  not  always  easy  to  impress  upon  the  clerks  the  import- 
ance of  so  gauging  the  work  that  both  men  will  be  busy  prac- 
tically all  the  time,  and  if  this  is  not  watched  closely  we  may 
find  one  clerk  going  through  an  entire  ledger  for  an  entry  or 
two  while  the  other  clerk  sits  patiently  or  sleepily  by  doing 
nothing ! 

BAD  OR  AMBIGUOUS  FIGURES  should  always  receive 
close  attention,  as  it  not  infrequently  happens  that  they  are 
posted  as  one  figure,  and  added  up  as  another.  Corrections, 
too,  require  careful  attention.  Erasures  should  always  be 
strictly  prohibited ;  and  where  hand-made  paper  is  used  for 
books,  they  should  be  keenly  watched  for,  as  a  clean  erasure 
may  easily  have  been  made.  It  is  very  important  that  the 
room  used  by  the  auditors  be  well  lighted,  or  mistakes  may 
easily  occur.  Where  a  correction  has  been  made,  care  must  be 
taken  to  insure  that  the  addition  and  posting  have  both  been 
altered.  In  a  continuous  audit  this  is  especially  important, 
but — as  it  has  already  been  noticed — it  need  not  now  be  dilated 
on. 

It  may  seem  almost  superfluous  to  say  that  the  clerk  calling 
back  should  always  speak  clearly,  but  experience  teaches  that 


32  AUDITING. 

this  is  a  matter  that  frequently  does  not  receive  the  considera- 
tion it  deserves.  Such  a  mistake  as  $200.25  being  posted 
$225.00  should  be  guarded  against  by  always  mentioning  the 
word  "  cents  "  in  calling  back  such  an  amount.  It  is  import- 
ant that  the  clerk  calling  should  learn  to  "  pull  with  "  the  one 
who  is  turning  over  folios.  This  is  a  habit  much  more  readily 
acquired  by  some  juniors  than  others — in  many  respects  it 
resembles  the  art  of  accompanying  in  music — and  the  senior 
who  has  found  a  youngster  to  suit  him  will  not  willingly  make 
a  change,  as  the  economy  of  nervous  force  consequent  upon 
perfect  accord  is  very  considerable. 

VERIFYING    ADDITIONS. 

In  all  cases  it  is  desirable,  although  it  is  not  always  prac- 
ticable, that  all  the  additions  should  be  verified.  In  every 
case,  however,  the  additions  of  the  private  ledger,  general 
ledger,  cash  books,  sales  books,  petty  cash  books  and  payrolls 
will  require  to  be  verified  in  detail  unless  the  auditor  can  satisfy 
himself  as  to  their  accuracy  by  intelligent  and  comprehensive 
tests.  This  should  always  be  done  when  the  other  work  con- 
nected with  the  same  book  is  being  done ;  for  if  the  designing 
bookkeeper  has  power  to  make  alterations  meanwhile  he  can 
afford  to  laugh  at  every  safeguard  against  fraud. 

It  is  hardly  necessary  to  add  that  the  verification  of  addi- 
tions though  purely  mechanical  is  most  important  work.  It  is 
especially  necessary  that  the  "  carried  forwards  "  be  checked 
on  to  the  following  page,  as  errors  frequently  occur  here. 
Also  when  verifying  the  additions  of  a  book  with  several  col- 
umns of  figures  it  is  important  to  see  that  the  distinction  be- 
tween the  various  columns  is  preserved  when  carrying  forward 
totals  from  one  page  to  another. 

THE  PREVIOUS  BALANCE  SHEETS. 

While  the  junior  clerk  is  checking  additions,  the  senior  will 
have  time  to  see  to  many  matters  which  require  his  attention. 


AUDITING    (up  to  THE  TRIAL  BALANCE).  33 

Foremost  among  these  will  be  the  comparison  of  the  ledgers 
with  the  last  balance  sheet — unless,  indeed,  the  principal  has 
already  dealt  with  this  point. 

It  is  very  generally  conceded  that  no  auditor  can  be  made 
liable  for  the  acts  or  omissions  of  his  predecessor  in  office; 
but  this  rule  must,  of  course,  be  strictly  applied,  and  an 
auditor  who  adopts  and  perpetuates  the  mistakes  of  his  pre- 
decessor would  not  on  this  account  alone  escape  the  conse- 
quences of  his  own  negligence.  It  is  important,  therefore, 
to  carefully  scrutinize  those  items  which,  in  the  ordinary 
course,  are  brought  forward  as  balances  from  one  year  to 
another.  In  so  far  as  their  correctness  cannot  be  tested  by  an 
examination  of  the  accounts  under  review,  the  present  auditor 
is  doubtless  not  responsible;  but  in  cases  where  a  careful  in- 
vestigation of  the  current  accounts  would  have  disclosed  an 
error  in  the  previous  accounts  it  might  well  be  held  that  the 
discovery  ought  to  have  been  made  and  that  failure  to  make 
it  was  the  result  of  negligence.  It  is  not  thought  necessary 
to  pursue  this  subject  in  detail.  It  may  be  pointed  out,  how- 
ever, that  the  mere  existence  of  a  ledger  account  headed 
"  Reserve,"  with  a  balance  to  the  credit  thereof,  should  not 
be  taken  as  conclusive  evidence  that  a  corresponding  amount 
of  profits  available  for  distribution  has  been  transferred  to 
Reserve;  while  it  would  be  only  prudent  to  see  that  proper 
depreciation  had  been  written  off  all  wasting  assets  in  prior 
years,  as  well  as  in  the  year  under  review. 

It  need,  perhaps,  hardly  be  added  that  it  is  important  that 
the  auditor  should  see  that  he  begins  his  investigation  at  the 
exact  point  where  the  previous  investigation  left  off — that  is 
to  say,  the  opening  balances  of  the  period  under  review  should 
in  all  cases  be  checked  and  agreed  with  the  previous  balance 
sheet.  This  applies  whether  or  not  the  accounts  for  the 
previous  period  were  checked  by  the  same  auditors.  Under 
normal  circumstances  this  checking  of  the  opening  balances 
would  probably  be  done  as  a  matter  of  course,  but  the  ques- 
tion as  to  its  necessity  might  sometimes  arise  where  it  is  the 


34  AUDITING. 

custom  to  start  an  entirely  new  set  of  books  with  each  financial 
year — ^more  especially  if  the  auditing  is  done  at  the  account- 
ant's office,  and  not  at  the  client's  place  of  business.  By  way 
of  showing  the  extreme  importance  of  adopting  this  some- 
what obvious  precaution,  it  may  be  added  that,  some  few  years 
since,  a  case  of  somewhat  extensive  fraud,  extending  over  a 
long  period  of  years,  transpired,  which  might  have  been  dis- 
covered at  any  time,  had  the  auditors  checked  the  starting 
balances  with  the  previous  year's  books. 


VOUCHERS. 

Much  might  be  written,  and  indeed,  has  been  written,  upon 
the  important  subject  of  vouchers;  it  is,  however,  impossible 
to  treat  the  matter  exhaustively  in  the  space  at  disposal. 

The  present  work  would,  however,  be  incomplete  without 
some  mention  of  the  matter,  which,  for  convenience  sake,  will 
be  dealt  with  under  the  following  heads: 

(a)  Receipts. 

(b)  General  Payments. 

(c)  Petty  Cash. 

(d)  Wages. 

(e)  Bank  Account,  &c. 
(/)  Journal  Entries,  &c. 

Each  of  these  involves,  for  its  complete  consideration,  the 
question  as  to  the  form  of  accounts  employed,  but  the  relative 
merits  of  the  various  forms  available  will  mostly  be  more  con- 
veniently dealt  with  at  a  later  period.  In  general  terms  it 
may  be  said  that  the  process  of  "  vouching  "  consists  of  obtain- 
ing evidence  (usually  documentary)  that  the  transactions  re- 
corded in  the  books  are  facts. 

(a)  RECEIPTS.— It  is  part  of  the  auditor's  duty  to  ascer- 
tain, as  far  as  possible,  that  all  cash  received  has  been  entered 
to  the  debit  of  the  cash  book.  The  usual  mode  of  verification 
available  will  be  a  comparison  of  the  details  of  the  bank  de- 


AUDITING    (up   to   THE   TRIAL   BALANCE).  35 

posits,  but  unless  the  entries  which  purport  to  be  a  copy  of  the 
deposit  slips  are  verified  at  bank  they  cannot  be  depended 
upon,  for  numerous  instances  have  been  disclosed  where  cash- 
iers have  systematically  kept  the  "  details  of  deposits  "  copy- 
book, or  stubs  in  agreement  with  the  cash  book  while  the 
actual  deposit  tickets  contained  different  items  but  identical 
totals. 

The  reason  for  this  is  obvious,  i.  e.,  the  covering  up  and 
"  carrying  "  of  collections  from  customers,  the  current  receipts 
being  used  to  cover  past  items  not  credited.  Many  of  these 
defaults  run  on  for  years  in  establishments  where  the  cashier 
has  access  to  the  customers'  ledgers,  and  where  collections  are 
not  looked  after  sharply  by  anyone  else. 

Some  years  ago  an  article  appeared  in  The  Journal  of  Com- 
merce, written  by  Mr.  D.  J.  Tompkins,  of  the  Guarantee  Com- 
pany of  North  America,  with  reference  to  customers'  accounts, 
which  we  reproduce. 

"As  an  officer  of  one  of  the  older  guarantee  companies,  the  writer 
has  had  over  twenty  years'  experience  of  claims  under  fidelity  bonds 
on  defaulting  employees.  Three-fourths  of  the  defaults  by  treasurers 
and  cashiers  accrue  by  embezzlement  of  remittances  received,  and 
then  by  concealing  the  theft  by  the  '  lapping '  system,  so-called.  For 
instance,  the  defaulter  embezzles  a  cash  payment  by  A  and  defers  entry 
of  such  payment  on  cash  book  until,  on  receiving  remittance  from  B, 
he  puts  B's  check  into  cash-drawer  and  into  bank  and  then  enters  A's 
payment  on  cash  book,  but  likewise  defers  entry  of  B's  remittance 
until  the  arrival  of  Cs  remittance  enables  him  to  enter  B's  payment  in 
similar  way.  He  has  to  continue  this  system  until  the  end,  or  until  the 
shortage  is  made  good.  The  more  items  stolen,  the  greater  the  number 
of  accounts  that  must  be  tampered  with  to  conceal  default. 

"  The  result  is  that  as  sundry  amounts  paid  in  by  customers  have 
not  yet  been  entered  by  cashier  on  cash  book,  and  hence  not  posted  by 
bookkeeper  to  credit  of  their  accounts  on  ledger,  their  balances  appear 
on  ledger  at  amounts  larger  than  actually  due  by  them.  Manifestly, 
therefore,  no  audit  can  be  complete  or  conclusive  as  to  the  existence  of 
a  default  without  the  auditor's  verification  of  the  ledger  balances  by 
communication  with  agents  and  customers. 

"However,  it  is  not  often  necessary  to  thus  verify  all  such  accounts 
to  determine  with  reasonable  certainty  if  such  default  exists.     If  de- 


36 


AUDITING. 


fault  exists  in  any  appreciable  amount  its  concealment  by  'lapping' 
will  involve  the  existence  of  irregularities  in  a  considerable  number 
of  such  accounts;  and  if  there  be,  say,  one  hundred  accounts  on  the 
ledger,  let  the  auditor  select  ten  or  fifteen  accounts  that  are  fairly  repre- 
sentative and  verify  those.  The  result  will  indicate  as  to  tlie  necessity 
of  verifying  the  remainder. 

"  Again,  there  is  another  means  of  more  certainly  determining,  right 
inside  the  office,  whether  this  lapping  system  is  in  vogue  to  conceal 
existing  default.  If,  as  should  be,  the  employee  is  required  to  make 
and  retain  on  file  in  the  office  a  carbon  duplicate  deposit  slip  showing 
items  deposited  in  bank  each  day,  the  auditor  should  compare  the  indi- 
vidual items  so  shown  deposited  with  the  items  on  cash  book  for  same 
day.  Let  him  make  such  comparison  for  three  or  four  days  of  each 
month.  If  he  finds  that  such  individual  items  correspond,  except  for 
explainable  differences,  he  may  feel  reasonably  assured  of  the  absence 
of  any  evidence  of  'lapping.'  But  if  he  finds  frequent  variances  be- 
tween such  items — if,  for  instance,  he  finds  on  certain  days  such  dis- 
crepancies as  shown  by  the  following,  viz.: 


Receipts   as   per   Cash   Book. 

Sept.  5. — Brown    $149.70 

Smith    205.00 

Jones   310.00 

Roberts    180.00 

Moore    45.00 

Thomas    22.50 


Total    $912.20 


Deposits   as   per   Slip. 

Check    $300.00 

275.00 

"    160.00 

"    121.70 

"    45.00 

Currency   10.50 


$912.20 


— in  such  case  the  auditor  should  realize  that  here  exists  the  indica- 
tion of  'lapping' — the  deposit  of  checks  in  different  amounts  from 
the  receipts  entered  on  cash  book — ^the  availing  of  a  deposit  of  remit- 
tances of  certain  customers  to  enable  the  cashier  to  enter  credit  to 
other  customers  for  amounts  previously  received  and  entry  of  which 
had  been  deferred — the  sure  sign  of  default.  True,  occasional  dis- 
crepancies of  this  kind  may  be  natural  and  legitimate,  but  if  such  dis- 
crepancies occur  frequently  the  auditor  should  know  that  a  thorough 
verification  of  all  accounts  should  be  at  once  begun.  If  a  carbon 
■duplicate  of  the  deposit  slip  be  not  retained  in  the  office,  the  auditor 
should  make  such  comparisons  from  copies  of  some  of  the  original 
slips  made  by  him  at  bank. 

"Since  railroad  auditors,  under  pressure  from  guarantee  companies, 
liave  begun  to  test  outstandings  in  the  accounts  at  large  freight  sta- 
tions, defaults ,  which  formerly  ranged  from  $10,000  and  upwards  in 


AUDITING    (up  to  THE  TRIAL  BALANCE).  37 

such  accounts  have  now  dwindled  to  an  average  of  only  $2,000  or 
$3,000.  Only  a  similar  test  of  ledger  accounts  will  curtail  the  large 
amount  of  defaults  now  so  frequently  sustained  by  insurance,  manu- 
facturing and  commercial  concerns." 

After  all,  the  only  satisfactory  verification  of  customers' 
accounts  is  by  direct  confirmation,  and  many  auditors  now 
advocate  the  issue  of  a  circular  to  the  customers,  requesting  a 
verification  of  their  accounts  as  quoted.  In  many  wholesale 
houses  and  manufacturing  establishments  this  method  is  per- 
fectly feasible,  but  in  retail  businesses  and  in  some  manufac- 
turing concerns  the  number  of  accounts  involved  renders  it 
impracticable  to  verify  all  the  accounts  in  this  manner.  In  such 
cases  tests  may  be  made  by  sending  the  requests  for  confirma- 
tion to  a  certain  percentage  of  the  customers.  The  auditor 
must  not  communicate  with  his  client's  customers  on  his  own 
responsibility,  but  must  have  the  authorization  of  his  client  for 
doing  so.  As  a  rule  it  is  preferable  to  conduct  the  verification 
in  the  client's  name,  provision  being  made — through  the  use 
of  a  special  post-office  box  or  otherwise — for  the  return  of 
the  customers'  confirmations  direct  to  the  a/uditor.  This 
method  of  verifying  the  accounts  receivable  is  especially  desir- 
able in  cases  of  grave  irregularity  when  some  special  inquiry 
becomes  absolutely  necessary  in  order  to  ascertain  the  actual 
position.  It  need  hardly  be  added  that  the  mere  statement 
by  a  customer  that  he  has  paid  his  account  cannot  always  be 
regarded  as  conclusive. 

Cash  sales  require  very  careful  scrutiny,  and  the  method 
of  internal  check  adopted  should  always  be  ascertained,  and, 
as  far  as  possible,  perfected.  Where  practicable,  it  is  most 
desirable  that  the  clerk  who  writes  up  the  cash  book  should 
not  be  the  one  who  receives  the  money. 

Special  items  of  receipt  will  be  more  conveniently  dealt  with 
when  considering  the  audit  of  various  kinds  of  accounts. 

(b)  GENERAL  PAYMENTS,  other  than  those  for  wages 
and  petty  cash,  should  (where  possible)  be  invariably  made 


38  AUDITING. 

by  cheque,  payable  to  "  order."  Even  where  the  amount  is 
small  this  method  of  payment  will,  in  the  vast  majority  of 
cases,  be  simpler,  as  well  as  safer,  than  cash  payments.  Such 
payments  by  cheque  hardly  require  vouching,  but  it  should 
nevertheless  be  done,  nor  will  the  process  be  difficult.  Re- 
ceipts can  readily  be  obtained  for  all  ordinary  payments, 
which  should  be  numbered  consecutively  (the  numbers  of  the 
cheques  are  very  useful  for  this  purpose  sometimes),  as  should 
also  the  items  in  the  cash  book. 

A  receipt  on  the  payee's  own  printed  form  is  very  much  bet- 
ter evidence  that  he  has  received  the  amount  stated  than  a 
receipt  on  the  form  of  the  payer,  although,  doubtless,  a  uni- 
form style  of  voucher  will  save  the  auditor's  time  slightly. 
From  both  points  of  view,  it  is  not  desirable  that  payers  should 
provide  their  own  form  of  receipt ;  be  this  as  it  may,  however, 
the  practice  exists,  and  will  probably  continue  to  do  so. 

Where  the  cheque-voucher  is  used,  the  detailed  examination 
of  the  original  purchase  invoices  can  frequently  be  dispensed 
with,  if  not  wholly  at  least  to  a  considerable  extent,  but  in  all 
cases  where  it  is  proposed  to  omit  the  inspection  of  the  original 
invoices  enough  of  them  should  be  examined  to  satisfy  the 
auditor  that  proper  precautions  are  being  taken  with  respect 
to  cash  discounts,  freight  allowances,,  short  weights,  &c.,  &c. 

Some  special  payments  cannot  be  vouched  in  the  regular 
way  {e.  g.,  the  purchase  of  securities),  but  satisfactory  evi- 
dence that  the  payment  was  actually  made,  and  value  received, 
should  always  be  obtained. 

(c)  PETTY  CASH.— Whatever  system  of  petty  cash  be 
adopted,  the  vouching  of  petty  cash,  as  a  whole,  will  be  the 
only  possible  real  verification  of  the  payments  made  from  cash 
to  petty  cash,  and  the  whole  matter  may  be  appropriately  con- 
sidered here.  The  actual  inspection  of  petty  cash  vouchers 
may,  or  may  not,  be  undertaken  by  the  auditor,  as  he  thinks 
fit.  In  the  former  case,  a  responsible  person  must  certify  the 
whole  of  the  items  en  bloc;  and  in  the  latter  case,  a  similar 


AUDITING    (up  to  THE  TRIAL   BALANCE).  39 

person  must  pass  each  separate  voucher.  Important  frauds 
are  hardly  likely  to  occur  in  petty  cash;  but,  as  likely  as  not, 
petty  peculations  will  arise,  if  an  efficient  supervision  be  not 
exercised.  No  auditor  can  properly  supervise  the  petty 
cashier,  and  it  is  well  to  acknowledge  the  fact  fully ;  he  may, 
however,  see  that  every  payment  has  been  duly  authorized 
by  the  responsible  head,  that  the  payments  made  by  the  cashier 
have  been  duly  acknowledged,  that  the  footings  of  the  petty 
cash  book  are  correct,  and  that  the  balance  unspent  is  in  hand. 
Beyond  this  he  should  not  attempt  to  go. 

Some  clients  have  a  very  bad  habit  of  making  comparatively 
large  payments  through  petty  cash.  This  should  be  discour- 
aged as  far  as  possible.  Some  have  a  still  worse  habit  of 
allowing  the  petty  cashier  to  receive  small  amounts;  this  is 
a  very  bad  system,  and  should  be  most  vigorously  contested. 
All  receipts  should  be  banked,  no  matter  how  trifling  in 
amount,  and  a  clerk  in  charge  of  cash  receipts  should  never 
be  in  charge  of  cash  payments  if  it  can  be  avoided. 

{d)  WAGES. — Instances  of  fraud  in  the  payment  of  wages 
are  among  the  most  frequent  of  those  that  come  under  the 
notice  of  an  auditor;  but,  from  the  very  nature  of  the  case, 
direct  evidence  of  proper  payment  is  all  but  impossible.  Sig- 
natures might  be,  and  frequently  are,  required  from  each  man 
receiving  wages;  but  some  men  can  only  sign  by  means  of 
affixing  their  "  mark,"  while  many  others  would  not  be  above 
"  going  shares  "  with  the  paying  clerk  in  anything  they  could 
get  over  their  due.  Circumstantial  evidence  is  thus  the  best 
available  for  the  auditor,  and  this  will  consist  in  a  good 
system  of  payment,  which  renders  fraud  improbable  by  reason 
of  the  number  of  persons  concerned  in  the  preparation  of  the 
pay-sheet  and  the  subsequent  payment.  Particulars  of  time 
worked,  or  piece-work  done,  should  be  certified  by  the  fore- 
men; the  calculations  of  wages  worked  by  one  office  clerk, 
and  checked  by  another;  the  cash  for  the  wages  made  up  by 
the  cashier,  and  the  wages  paid  by  him  or  his  deputy  in  the 
presence  of  a  factory  manager.     Where  possible,  a  cheque 


40  AUDITING. 

should  always  be  drawn  for  the  exact  amount  of  wages  re- 
quired. The  auditor  should  inquire  as  to  the  particular  sys- 
tem adopted,  and  should  ascertain  that  it  is  really  carried  out ; 
sometimes  it  might  be  well  for  him  to  unexpectedly  put  in  an 
appearance  when  the  wages  were  being  paid.  The  additions  of 
the  pay  rolls  should  be  verified,  and  a  week  or  two's  wages 
taken  at  random  and  compared  with  the  original  time  books 
or  time  clock  records. 

(e)  BANK  ACCOUNT,  &c.— All  deposits  with  the  bank 
should  be  checked  off  against  the  pass  book.  The  composi- 
tion of  a  few  such  payments  may  be  advantageously  compared 
with  the  items  which  they  purport  to  represent,  and  any  irregu- 
larity carefully  followed  up.  The  credit  side  of  the  cash  book 
should  also  be  checked  with  the  paid  cheques,  and  any  dis- 
agreement of  the  names  should  receive  careful  attention.  The 
bank  balance  must,  of  course,  be  verified,  and  if  the  auditor 
has  not  himself  received  the  pass  book  from  the  bank,  he 
should  make  a  point  of  either  obtaining  the  bank's  certificate 
showing  the  balance  as  of  the  date  of  the  account,  or  take 
it  back  to  the  bank,  in  person;  otherwise  he  will  run  the  risk 
of  never  having  seen  the  real  pass  book  at  all.  A  list  of  the 
cheques  outstanding  should  be  retained,  and  it  should  be  ascer- 
tained afterwards,  either  by  a  second  writing-up  of  the  pass 
book  or  by  inquiry  of  the  bank,  whether  the  amounts  agree. 
If  the  time  of  the  proposed  audit  is  known,  fraud  may  easily 
be  committed  and  the  cash  inflated  by  drawing  a  cheque  at 
the  last  moment  which  will  be  "  outstanding." 

The  English  clearing  houses  clear  the  same  day,  which  cuts 
off  the  kiting  of  "  outstandings  "  so  prevalent  in  America  and 
encouraged  by  our  **  next  morning  "  clearing. 

Another  fact  which  deserves  mention  is  that  the  English 
system  of  bank  pass  books  is  superior  to  ours,  at  least  from 
the  auditor's  standpoint. 

The  introduction  of  adding  and  listing  machines  in  Amer- 
ican banks  is  responsible  for  the  practical  abolition  of  the  old 


AUDITING    (up  to  THE  TRIAL  BALANCE).  4I 

custom  of  writing  the  cheques  in  detail  in  the  pass  book.  The 
consequences  of  this  is  that  many  investigations  are  greatly- 
hampered  by  the  lack  of  details,  which  at  one  time  were  al- 
ways available,  but  which  are  now  recorded  on  loose  sheets 
of  paper.  These  lists  are  almost  invariably  destroyed,  and 
cannot,  as  a  rule,  be  found  when  needed. 

Still  another  "  labor  saving  "  custom  which  has  crept  in  is 
the  mere  writing  of  the  word  "  Balance  "  in  the  pass  book, 
neither  the  footing  of  the  deposits  nor  the  aggregate  of  the 
paid  cheques  being  shown. 

In  view  of  the  numerous  defalcations  which  have  arisen 
through  manipulation  of  bank  accounts,  including  the  use  of 
duplicate  pass  books,  it  might  properly  be  brought  to  the  at- 
tention of  the  banks  that  the  interests  of  their  patrons  arc  not 
being  properly  safeguarded. 

The  ideal  way  would  be  to  have  each  deposit  accompanied 
by  a  duplicate  ticket,  to  be  initialed  by  the  receiving  teller  and 
returned  to  the  depositor;  to  have  the  cheques  written  up  in 
detail  in  the  pass  books  and  properly  identified  by  their  num- 
bers or  by  dates. 

This  suggestion,  of  course,  will  not  appeal  to  bankers,  who 
are  constantly  trying  to  reduce  rather  than  to  increase  ex- 
penses, but  it  would,  nevertheless,  be  a  great  protection  to 
their  customers.  Such  a  system  is  in  general  use  in  England, 
and  judging  by  the  dividend  rates  of  most  American  banks 
its  adoption  here  would  not  increase  expenses  to  such  a  point 
as  would  materially  affect  profits. 

In  a  continuous  audit,  the  vouching  should  always  be  kept 
as  close  up  to  date  as  possible,  while  the  bank  and  {all)  cash 
balances  should  be  verified  at  every  visit.  A  cash  balance  will 
sometimes  be  found  to  consist  largely  of  "  I  O  U's  " ;  this 
should  always  be  discouraged  as  far  as  possible.  In  any  event, 
the  "  I  O  U's  "  should  be  initialed  by  someone  in  authority. 

(/)  JOURNAL  ENTRIES,  &c.— The  modern  journal  be- 
ing the  book  of  first  entry  in  which  comparatively  unusual 


42  AUDITING. 

transactions  are  recorded,  it  becomes  just  as  important  that 
the  journal  entries  should  be  fully  vouched  as  it  is  that  those 
relating  to  cash  receipts  and  payments  should  be  subjected 
to  the  same  scrutiny.  If  the  correctness  of  all  entries  passed 
through  the  journal  be  taken  for  granted,  there  is  absolutely  no 
limit  to  the  amount  of  falsification  that  might  be  committed 
with  impunity.  Improper  journal  entries  might  be  made  with 
one  of  two  objects — namely,  (i)  to  conceal  defalcations,  as, 
for  instance,  when  customers  are  improperly  credited  with  the 
amount  embezzled,  and  a  corresponding  debit  made  to  Allow- 
ance or  Bad  Debts;  (2)  to  fraudulently  exaggerate  the  profits 
of  the  undertaking — e.  g.,  by  crediting  nominal  accounts  and 
debiting  real  accounts  with  payments  that  cannot  properly  be 
capitalized.  It  is  impossible  to  deal  in  detail  with  the  vouch- 
ing of  journal  entries,  on  account  of  the  unlimited  nature  of 
the  transactions  that  might  be  recorded  in  this  book;  it  may 
be  stated,  however,  that  only  the  evidence  of  some  disinter- 
ested party — or  that  being  unobtainable,  the  evidence  of  some 
person  absolutely  above  suspicion — should  be  accepted  as  a 
voucher,  and  in  the  case  of  all  important  entries  the  auditor 
should  take  steps  which  will  enable  him  to  form  a  definite 
opinion  of  his  own  with  regard  to  the  matter. 

A  practical  consideration  in  connection  with  vouching  is 
with  regard  to  the  actual  marks  an  auditor  should  make  to 
indicate  that  this  work  has  been  performed.  In  the  first  place, 
the  voucher  should  be  so  marked  that  it  cannot  be  afterwards 
used  as  a  voucher  in  support  of  another  entry;  and,  in  the 
second  place,  the  entry  that  has  been  vouched  should  be  so 
marked  that  the  auditor  can  afterwards  readily  ascertain  what 
items  remain  unvouched.  With  regard  to  the  marking  of  the 
vouchers,  the  following  methods  are  in  use: — 

( 1 )  A  large  "tick  "  across  the.  face  of  the  voucher. 

(2)  The  audit  clerk's  initials,  or  the  letter  "  E." 

(3)  A  rubber  stamp  bearing  the  name  of  the  firm — either 
with  or  without  the  clerk's  initials. 

(4)  The  auditor's  initial  cut  out  by  using  a  conductor's 
punch. 


AUDITING    (up  to  THE  TRIAL  BALANCE).  43 

As  the  main  object  is  to  so  disfigure  the  voucher  that  it  can- 
not be  again  used  in  support  of  another  entry,  it  is  not  very 
material  which  of  these  be  employed.  It  may  be  remarked, 
however,  that  initials  necessarily  take  longer  to  make  than  a 
tick  or  an  impression  from  a  rubber  stamp.  The  third  method 
is,  it  is  thought,  generally  to  be  preferred,  as  indicating  clearly 
who  is  responsible  for  the  cancellation.  In  other  cases  the 
record  in  the  audit  note-book  ought  to  be  sufficient  for  this 
particular  purpose.  An  additional  reason  for  preferring  the 
third  method  is  that  it  is  the  neatest,  and  as  vouchers  still  con- 
tinue to  form  a  part  of  the  client's  business  records  after  ex- 
aminations thereof — as  well  as  the  possibility  of  their  being 
produced  in  court  as  evidence  in  litigation — the  desirability  of 
using  the  neatest  method  is  obvious.  With  regard  to  the 
marking  of  the  entries  in  the  books  as  being  vouched,  some 
firms  employ  a  distinct  "  V,"  which  has  the  advantage  of  be- 
ing clearly  distinguished  among  various  classes  of  ticks,  and 
so  enabling  a  list  of  missing  vouchers  to  be  more  readily  com- 
piled. Sometimes,  however,  an  imperfect  voucher  is  accepted, 
and  in  such  case  it  seems  desirable  that  a  special  form  of  mark 
should  be  employed,  so  as  to  guard  against  the  real  voucher 
being  produced  in  support  of  another  entry. 

Where  the  auditor  suspects  irregularities  that  he  is  unable 
actually  to  detect,  he  may  frequently  gain  his  point  by  feigning 
laxity  in  his  method  of  vouching;  this  will  often  serve  to  in- 
duce that  carelessness  on  the  part  of  the  defaulter  that  is  nec- 
essary for  his  detection  and  exposure.  The  author,  who  has 
had  a  considerable  experience  of  frauds  of  all  kinds,  has  found 
this  method  work  out  admirably ;  it  is,  however,  necessary  that 
it  be  practiced  with  discretion,  if  one  wishes  to  avoid  the 
charge  of  being  actually  lax. 


BILLS    OF    EXCHANGE. 

A  few  words  on  the  subject  of  bills,  or  as  they  are  usually 
called  "  notes,"  will  not  be  out  of  place. 


44  AUDITING. 

NOTES  PAYABLE  will  present  but  little  difficulty;  the 
returned  note  forms,  of  course,  the  voucher  for  the  payment 
of  notes  matured,  while  the  notes  running  (as  shown  by  the 
notes  payable  book)  will  explain  the  balance  of  the  notes  pay- 
able account  in  the  ledger. 

Notes  payable  are  frequently  written  on  special  forms  with 
stubs  attached,  in  which  case  it  is  important  to  see  that  all 
are  accounted  for.  It  is  not  likely  that  they  will  be  numbered 
by  the  stationer,  as  a  business  man  usually  does  not  care  to 
publish  generally  the  number  of  notes  he  issues. 

Cases  have  been  know^n  where  notes  payable  for  large  sums 
have  been  negotiated  without  any  entry  therefor  in  the  books, 
and  special  care  should  be  taken  to  cover  this  point.  Of 
course,  where  no  grounds  for  suspicion  have  arisen  during  the 
audit,  it  may  not  be  thought  advisable  to  make  any  special 
examination  along  this  line ;  but  if  any  doubts  have  presented 
themselves  it  is  well  to  make  inquiry  at  all  of  the  banks  with 
which  the  client  is  connected  as  to  the  aggregate  of  loans  ob- 
tained therefrom,  and  to  make  such  further  inquiries  as  may 
be  feasible. 

NOTES  RECEIVABLE  require  more  careful  considera- 
tion. The  notes  receivable  book  should  be  dealt  with  seriatim; 
all  notes  matured  or  discounted  should  be  traced  into  the  cash 
book,  and,  if  protested,  back  to  the  debit  of  the  customer.  All 
notes  protested,  or  still  running  and  undiscounted,  should  be 
in  hand,  and  this  fact  must  be  verified. 

Discount  deducted  from  notes  discounted  should  be  looked 
into  to  a  certain  extent,  although  not  necessarily  exhaustively ; 
also,  the  important  question  of  the  liability  upon  notes  under 
discount,  and  the  value  of  notes  protested,  must  not  be  lost 
sight  of.  Both  these  points  require  to  be  considered  when 
the  provision  for  bad  and  doubtful  debts  is  dealt  with. 

Protested  notes  should  never  be  allowed  to  remain  in  the 
notes  receivable  account  of  the  ledger,  but  should  be  imme- 


AUDITING    (up  to  THE  TRIAL  BALANCE).  45 

diately  charged  back  to  the  debtor  in  the  event  of  their  non- 
payment when  due. 

CONSIGNMENTS. 

It  is  very  desirable  that  all  points  connected  with  consign- 
ments be  thoroughly  verified,  and  for  this  purpose  letter-files, 
copy  letter-books,  and  accounts  current  should  be  freely  con- 
sulted. There  is,  however,  nothing  particular  in  the  nature 
of  the  transactions  (save  the  question  of  foreign  currency, 
which  is  dealt  with  elsewhere)  that  calls  for  special  comment 
here. 

THE    TRIAL    BALANCE. 

It  should  be  the  auditor's  aim,  so  far  as  possible,  to  carry 
each  department  of  his  investigation  right  up  to  the  trial  bal- 
ance at  the  same  sitting.  Of  course,  in  a  large  audit,  this  can 
very  rarely  be  accomplished;  but  the  auditor  must  always 
remember  that  there  is  material  danger  in  leaving  any  portion 
unfinished  in  the  hands  of  bookkeepers  or  cashiers,  who — for 
all  he  can  know  to  the  contrary — may  manipulate  the  figures 
during  the  course  of  the  audit. 

The  auditor,  therefore,  should  endeavor  to  fix  everything 
up  as  he  goes  along,  and  where  he  cannot  finish  the  same  day, 
he  will  do  well  to  keep  possession  of  the  books  and  documents 
until  he  can.  In  fact,  he  should,  so  far  as  possible,  keep  every- 
thing in  his  own  hands  until  the  audit  is  completed  as  far  as 
the  trial  balance.  Having  once  secured  a  trial  balance  that  he 
knows  has  not  been  tampered  with,  the  auditor  may  cease  to 
trouble  himself  about  the  materials  from  which  it  was  built 
up — they  may  be  manipulated  and  altered  up  and  down,  but 
he  holds  in  his  own  hand  the  key  of  the  whole  position.  Nor 
need  the  course  indicated  cause  offense,  or  even  excite  sus- 
picion, if  carried  out  with  tact.  It  is  generally  an  easy  mat- 
ter to  hang  on  to  a  list  of  balances,  and  even  where  it  is  not 
practicable  to  retain  uninterrupted  possession  of  a  book  until 
it  is  finished,  a  few  notes  and  private  marks  will  often  serve 


46  AUDITING. 

the  purpose.  It  is  not  a  difficult  matter  to  acquire  a  "  tick," 
which,  while  looking  much  the  same  as  any  other,  can  be  in- 
stantly distinguished  from  a  forgery.  A  man  forging  ticks 
will  be  much  less  careful  as  to  their  form  than  a  man  forging 
initials,  and  can  thus  be  more  often  detected.  It  is  not  a  bad 
plan  to  carry  about  one's  own  colored  ink,  and  to  take  care 
that  it  is  a  different  make  from  that  in  general  use  at  the  offices 
where  the  audit  is  conducted.  The  auditor,  however,  must  be 
careful  not  to  talk  about  these  things;  and  he  should  also  be 
careful  not  to  leave  his  ink  about.  It  is  often  a  great  advan- 
tage to  employ  ink  of  a  different  color  to  that  used  at  the  pre- 
ceding audit. 

BALANCING. 

In  the  foregoing  paragraph  it  has  been  assumed  that  an 
exact  balance  has  been  arrived  at  by  the  bookkeepers  before 
the  auditor  commences  his  investigation.  This,  of  course,  is 
as  it  should  be,  for  clearly  it  is  no  part  of  the  auditor's  duties 
(as  such)  to  balance  the  books.  The  question  arises,  how- 
ever, as  to  whether  an  auditor  is  ever  justified  in  passing  ac- 
counts that  do  not  exactly  balance.  Obviously,  accounts  that 
do  not  balance  cannot,  in  the  nature  of  things,  be  entirely 
accurate;  but  so  long  as  the  auditor  is  satisfied  that  the  dis- 
crepancy arises  from  one  error,  and  not  from  the  combined 
effect  of  numerous  errors,  and  so  long  as  the  difference  is  so 
small  as  to  have  no  practical  effect  upon  the  ultimate  result,  the 
absence  of  an  accurate  balance  may  sometimes  be  disregarded. 
Here,  as  elsewhere,  however,  much  depends  upon  circum- 
stances; a  nominal  or  private  ledger — or  indeed,  any  ledger 
with  less  than,  say,  500  accounts — ought  certainly  to  balance 
exactly;  on  the  other  hand,  it  may  be  impracticable  to  insist 
on  an  absolute  balance  with  a  large  individual  ledger — hence 
the  importance  of  these  balances  being  tested  at  frequent 
intervals,  say,  monthly  at  least. 

METHODS  OF  BALANCING.— In  private  audits  it  not 
infrequently  happens  that  the  auditor  is  requested  to  balance 


AUDITING    (up   to   THE   TRIAL   BALANCE).  47 

the  books.    The  detection  of  errors  in  balancing  is  thus  a  mat- 
ter with  which  an  auditor  occasionally  has  to  deal,  although  it 
does  not  in  any  sense  form  part  of  the  actual  audit  itself. 
There  are  two  modes  of  seeking  for  errors  in  balancing: — 

I.  By  localizing  the  error. 
II.  By  tabulating  the  ledger  accounts. 

LOCALIZING  THE  ERROR.— This  is,  of  course,  best 
accomplished  by  framing  the  system  of  accounts  upon  such 
lines  that  each  separate  ledger  is  "  self -balancing."  Where 
this  has  been  done,  it  is  a  very  simple  matter  to  see  in  which 
ledger  or  ledgers  the  discrepancy  arises,  and  the  field  is  at 
once  narrowed  accordingly.  It  may  easily  happen,  however, 
that  the  various  ledgers  have  not  been  framed  upon  self-bal- 
ancing principles ;  even  then  it  does  not  necessarily  follow  that 
the  error  cannot  be  localized.  If  the  cash  book  be  in  tabular 
form,  or  if  there  be  separate  subsidiary  cash  books,  the  equiva- 
lent of  a  controlling  account  can  almost  always  be  con- 
structed; transfers  from  one  ledger  to  another  may  compli- 
cate matters,  but  unless  such  transfers  are  much  more  numer- 
ous than  is  usual,  they  will  hardly  present  any  very  seriou? 
difficulty.  On  the  other  hand,  it  is  not  often  practicable  to 
apply  this  method  if  it  necessitates  an  analysis  of  the  cash 
book. 

When  the  books  of  original  entry  have  not  been  in  the  first 
instance  so  formulated  as  to  readily  lend  themselves  to  the 
construction  of  self-balancing  ledgers,  one  of  the  many  "  proof 
and  balance  "  systems  may  be  used.  There  are  so  many  of 
these  offered,  and  their  claims  so  varied,  that  space  will  not 
permit  going  into  details. 

An  auditor  will  frequently  be  asked  to  point  out  the  best 
method  of  preventing  errors  from  remaining  undiscovered 
until  after  the  trial  balance  is  taken  off,  but  so  much  depends 
on  the  person  using  one  of  these  "  systems  "  that  it  is  usually 
advisable  to  recommend  to  him  that  he  give  several  of  them 
a  practical  test  and  choose  the  best  himself. 


48  AUDITING. 

TABULATING  THE  LEDGERS.— This  is  a  method 
which  is  sometimes  adopted  where  the  number  of  ledger  ac- 
counts is  not  large,  and,  where  practicable,  it  is  extremely 
thorough.  It  consists  of  making  an  abstract  of  every  ledger 
account  upon  sheets,  which  are  virtually  tabular  ledgers. 
When  the  abstract  has  been  completed,  the  checking  of  the 
cross-additions  proves  the  extraction  of  the  ledger  balances, 
while  a  comparison  of  the  longitudinal  totals  with  the  opening 
balances,  day  book  totals,  total  of  cash  received,  &c.,  will 
show  in  which  direction  the  error  lies.  Thus,  if  the  total 
"  Goods  Sold  "  does  not  agree  with  the  total  "  Sales  Account " 
in  the  general  ledger,  there  is  clearly  an  error  in  the  postings 
or  the  additions  of  the  sales  books.  Many  accountants,  how- 
ever, and  among  them  the  authors,  prefer  to  carefully  re-check 
the  ledger,  item  for  item,  rather  than  adopt  such  a  laborious 
process  of  localizing  the  error — especially  when  it  is  remem- 
bered that  even  when  the  abstraction  of  the  ledger  has  been 
completed,  the  localization  has  been  directed,  not  to  one  ledger 
account,  but  to  one  subsidiary  book. 

From  the  authors*  point  of  view,  the  chief  value  of  the 
tabulation  of  the  ledgers  is  in  the  event  of  it  being  necessary 
to  convert  books  previously  kept  upon  single  entry  into  double 
entry:  this  is  a  feat  which  is  sometimes  necessary  when  ex- 
amining the  books  of  an  undertaking  about  to  be  converted 
into  a  corporation,  or  when  endeavoring  to  frame  a  deficiency 
account  in  cases  of  insolvency. 


AUDIT    OF    CORPORATIONS. 

The  chief  points  arising  in  the  course  of  the  audit  of  a  cor- 
poration that  do  not  occur  in  the  audit  of  a  private  firm  may 
be  divided  under  the  following  heads : — 

(a)  The  audit  of  capital  stock  and  bond  accounts. 

(b)  The  audit  of  dividend  and  interest  accounts. 

(c)  Compliance  with  the  various  statutory  requirements. 


AUDITING    (up  to  THE  TRIAL   BALANCE).  49 

(a)  THE  AUDIT  OF  CAPITAL  STOCK  AND  BOND 
ACCOUNTS.— The  main  points  are:  (i)  Does  the  stated 
amount  of  issued  capital  represent  a  valid  allotment  to  bona 
Me  applicants?  To  ascertain  this,  the  auditor  must  see  that 
the  amount  is  within  the  authorized  issue,  that  the  various 
classes  of  shares  (if  there  be  classes)  are  in  accordance  with 
the  certificate  of  incorporation,  that  the  minutes  of  allotment 
are  in  order,  that  the  allottees  have  agreed  to  become  share- 
holders to  an  extent  not  less  than  the  amount  of  their  respec- 
tive allotments,  that  the  aggregate  number  of  shares  actually 
issued  to  the  various  allottees  is  equal  to  the  total  number 
stated  to  have  been  issued,  and  that  the  required  deposit  has 
been  paid.  (2)  Has  the  amount  stated  to  have  been  paid  up 
been  actually  received  in  cash,  or  else  for  property  under  a. 
valid  contract? 

PREMIUMS  received  on  the  issue  of  shares  should  prefer- 
ably be  credited  to  a  special  Premiums  Account,  or  Capital  Sur- 
plus, and  it  is  thought  better  that  they  should  thus  be  shown 
as  a  separate  item  upon  all  succeeding  balance  sheets.  There 
is,  however,  no  law  to  forbid  such  premiums  being  credited 
to  Reserve,  or  even  to  Profit  and  Loss  Account. 

Where  a  commission  is  paid  on  the  underwriting  or  placing 
of  shares,  it  is  usual  to  anticipate  this  by  first  issuing  the  stock 
at  par  to  a  syndicate,  because  in  most  of  the  States  stock  can- 
not be  validly  issued  at  less  than  par.  In  some  instances,  how- 
ever, where  the  company's  stock  sells  at  a  premium,  stock  is 
sold  above  par,  and  a  commission  is  paid  to  an  underwriting 
syndicate. 

In  this  case  the  commission  should  be  charged  against  the 
premium,  and  the  net  surplus  carried  to  special  Premiums  or 
Capital  Surplus  Account. 

At  subsequent  audits  it  should  be  ascertained  that  the  capi- 
tal stock  ledgers  balance ;  the  author  never  heard  it  contended 
that  a  full  examination  of  the  stock  ledger  was  part  of  an 
ordinary  audit. 


50  AUDITING. 

Bonds,  however,  are  not  subject  to  the  same  restrictions  as 
$tock,  and  can  be  issued  at  a  discount.  Where  bonds  were 
issued  for  construction  purposes  it  was,  until  comparatively 
recently,  usual  (particularly  among  railroads  and  public  serv- 
ice corporations)  to  capitalize  the  entire  discount  on  the  theory 
that  it  really  represented  actual  additional  cost  of  property  for 
which  the  proceeds  of  the  bond  sale  were  used.  In  fact,  prior 
to  July  I,  1907,  when  the  Interstate  Commerce  Commission's 
revised  classification  of  accounts  went  into  effect  this  practice 
had  the  sanction  of  that  Commission. 

It  is,  however,  becoming  recognized  that  discount  on  bonds 
is  after  all  only  an  adjustment  of  the  interest  rate — whether 
due  to  insufficient  security  of  principal  or  to  a  nominal  rate  of 
interest  lower  than  the  ruling  market  rate  is  immaterial — and 
that  such  discount  should  be  charged  off  to  Revenue.  If  a 
corporation  has  advisedly  issued  a  four  per  cent,  bond  on  a 
six  per  cent,  basis,  why  should  the  Revenue  Account  not  show 
this  state  of  affairs?  Certainly,  if  the  par  of  the  company's 
credit  were  six  per  cent,  and  the  bonds  bore  six  per  cent,  and 
were  issued  at  par,  no  one  would  question  the  propriety  of 
charging  the  entire  six  per  cent,  against  Revenue  annually. 

The  scientific  method  of  dealing  with  the  discount  (termed 
amortization)  is  to  write  it  off  in  instalments  during  the  life 
of  the  bonds,  so  that  the  aggregate  of  the  discount  and  the 
nominal  interest  charged  to  Revenue  Account  is  the  actual 
amount  of  interest  paid  on  the  proceeds  of  the  bonds.  Where, 
however,  an  extremely  conservative  management  chooses  to 
write  off  the  discount  over  a  much  shorter  period  than  the 
life  of  the  bonds,  or  even  in  one  year,  no  valid  objection  could 
well  be  raised.  In  this  connection  it  may  be  of  interest  to  note 
that  the  Public  Service  Commission  of  the  State  of  New  York 
(Second  District),  in  the  uniform  systems  of  accounts  recently 
prescribed  for  the  various  classes  of  public  service  corpora- 
tions under  its  jurisdiction,  expressly  forbids  the  charging  of 
discount  on  bonds  to  any  account  representing  the  cost  of 
property,  and  directs  the  discount  to  be  amortized  or,  if  de- 
sired, written  off  in  a  shorter  period  than  the  life  of  the  bonds. 


AUDITING    (up   to   THE  TRIAL   BALANCE).  51 

In  view  of  recent  decisions  of  the  courts,  it  is  a  grave  ques- 
tion as  to  whether  they  would  uphold  the  custom  of  capitaliz- 
ing the  discount,  and  if  the  question  at  issue  happened  to  be 
the  liability  of  directors  for  the  payment  of  dividends  out  of 
capital,  the  chances  would  probably  be  very  much  against  the 
directors. 

When  bonds  are  sold  above  par  the  premium  should  be 
credited  to  a  Reserve  or  Suspense  Account  and  distributed  to 
the  credit  of  Revenue  over  the  life  of  the  bonds.  This  course, 
which  is  the  converse  of  amortizing  the  discount  on  bonds,  re- 
sults in  the  Profit  and  Loss  Account  being  debited  with  the 
interest  actually  paid  on  the  bonds,  i.  e.y  the  difference  between 
the  nominal  interest  and  the  premium  received. 

It  might  also  be  permissible  to  use  the  entire  amount  of  the 
premium  in  reducing  the  book  value  of  intangible  assets  or 
absorbing  depreciation  of  fixed  assets  caused  by  decreases  in 
values  not  resulting  from  the  ordinary  operations  of  the  busi- 
ness. Objection,  however,  should  be  raised  to  treating  the 
entire  premium  as  a  current  earning  of  the  year  in  which 
received. 

The  trustee  of  the  bonds  and  the  registrar  of  the  capital 
stock  (if  registered)  should  be  communicated  with  and  their 
certificates  of  the  amounts  of  bonds  and  stock  outstanding 
compared  with  the  corresponding  accounts  on  the  books  of  the 
corporation. 

(6)  THE  AUDIT  OF  PAYMENTS  FOR  DIVIDEND 
AND  INTEREST  is  not  usually  a  difficult  matter.  A  list 
of  stockholders  should  be  handed  to  the  auditor,  showing 
the  number  of  shares  held  by  each  stockholder  on  the  day  the 
dividend  was  declared,  and  the  amount  of  dividend  due.  The 
footings  of  this  list  should  be  checked,  and  the  totals  agreed 
with  the  amounts  of  shares  issued  and  dividends  payable  re- 
spectively; it  must  also  be  seen  that  the  rate  of  dividend  is 
correctly  calculated  in  toto.  A  few  of  the  larger  amounts, 
taken  at  random,  may  be  advantageously  compared  with  the 
stock   ledger,    and   the    calculations    checked;    but  it    is    not 


52  AUDITING. 

generally  essential  that  the  whole  list  be  exhaustively  verified. 
Many  large  concerns  draw  one  cheque  for  the  whole  amount 
of  the  dividend,  and  pay  it  into  a  separate  banking  account, 
against  which  the  dividend  cheques  are  issued.  Where  this 
method  is  adopted,  it  is  a  comparatively  simple  matter  to 
vouch  the  payments  and  verify  the  amount  of  outstanding 
dividends — which  latter  will,  of  course,  agree  with  the  balance 
of  the  pass  book.  Where  dividends  are  paid  in  cash,  or  by 
cheque  upon  the  ordinary  banking  account,  the  vouching  be- 
comes merged  in  the  vouching  of  the  general  payments.  The 
outstanding  dividends  will  not  be  so  easily  traced,  but  will 
present  no  special  difficulty  that  requires  particular  mention 
here. 

It  is  also  usual  to  draw  one  cheque  for  the  whole  amount 
of  each  coupon  on  a  bond  issue,  and  the  unpaid  coupons  will 
be  represented  by  the  balance  of  the  pass  book.  The  paid 
coupons  should  be  cancelled  and  pasted  in  a  book,  and  sub- 
mitted for  inspection.  Non-compliance  with  these  precau- 
tions might  easily  result  in  part  of  the  coupons  being  paid  a 
second  time,  and  the  failure  to  preserve  them  may  ultimately 
result  in  the  trustee  declining  to  satisfy  the  mortgage  of  record. 

The  old-fashioned  manila  leaved  invoice  book  can  be  used 
advantageously  in  filing  coupons  by  using  one  page  for  each 
bond;  by  taking  care  that  the  pages  of  the  book  correspond 
with  the  bond  numbers,  almost  instant  reference  may  be  had 
to  missing  coupons. 

In  the  case  of  all  companies  most  of  the  following  statis- 
tical books  are  practically  indispensable,  whether  required  by 
statute  or  not : — 

Subscriptions  and  allotments  book. 

Stockholders'  and  registered  bondholders'  address  books. 

Call  books. 

Stock  ledger. 

Bond  ledger. 

Transfer  book. 


AUDITING    (up  to  THE  TRIAL  BALANCE).  53 

Strictly  speaking  there  is  nothing  to  audit  in  these  various 
books — ^because  they  are  statistical  books  merely,  and  not 
books  of  account — but  the  auditor  should  satisfy  himself  that 
the  records  are  kept  in  the  prescribed  form,  and,  prima  facie, 
correctly.  In  addition,  he  will  do  well  to  ascertain  that  all 
mortgages  that  require  recording  have  been  properly  attended 
to. 

(c)  COMPLIANCE  WITH  THE  CHARTER  AND  BY- 
LAWS, BOARD  MINUTES,  &c.— Under  this  heading  it  is 
difficult  to  profitably  draw  attention  to  any  specific  points.  It 
may  be  mentioned,  however,  that  it  is  not  merely  expedient, 
but  also  absolutely  necessary,  that  the  auditor  should  carefully 
peruse  such  of  these  documents  as  may  relate  to  any  particular 
audit,  with  a  view  to  modifying  his  course  of  action  accord- 
ingly. The  special  points  to  which  it  will  be  necessary  for  him 
to  direct  attention  are,  so  far  as  the  capital  is  concerned,  as 
to  whether  it  has  been  duly  authorized ;  so  far  as  the  accounts 
are  concerned,  that  any  special  points  raised  in  these  documents 
are  borne  in  mind  when  considering  the  method  upon  which 
the  accounts  have  been  framed;  and,  so  far  as  the  question 
of  profits  available  for  dividend  is  concerned,  as  to  whether 
all  stipulations  as  to  certain  profits  being  carried  to  reserve, 
or  applied  to  the  future  redemption  of  bonds  by  the  creation 
of  sinking  funds,  &c.,  have  been  properly  dealt  with. 

It  is  most  important  that  the  minute  books  of  the  board  of 
directors,  committees,  &c.,  be  submitted  to  the  auditor  in  all 
cases. 

This  matter  is  dealt  with  further  on  and  need  not  be  con- 
sidered in  detail  here. 

In  the  case  of  certain  companies  it  is  also  desirable  that 
particular  attention  should  be  directed  to  the  various  contracts 
connected  with  the  original  formation  of  the  company.  The 
prospectus  should  be  very  carefully  scanned,  with  a  view  to 
seeing  that  any  special  provisions  laid  down  therein  are  also 
included  in  the   regulations  of   the  company  and  have  been 


54  AUDITING. 

acted  upon.  It  is  naturally  difficult,  if  not  actually  impossible, 
to  speak  exhaustively  in  this  connection;  but  it  may  be  men- 
tioned that,  supposing  a  prospectus  states,  as  it  sometimes 
does,  that  the  officers  will  not  taken  any  salaries  unless  the  com- 
pany has  made  profits,  or  until  a  certain  dividend  has  been 
paid  to  stockholders,  then,  whether  or  not  a  similar  provision 
is  contained  in  the  company's  by-laws,  it  is  necessary  that 
the  auditor  should  see  that  it  has  been  complied  with  in  the 
accounts  which  come  before  him  for  certification.  On  this 
point,  however,  nothing  more  than  general  hints  can  be  given. 


CHAPTER  II. 


METHODS    OF    ACCOUNT. 

(Suggested  in  the  Course  of  Audit.) 


It  is  not  Strictly  any  part  of  the  auditor's  duty  to  offer 
suggestions  or  issue  instructions  as  to  the  system  of  accounts 
to  be  adopted,  but  on  account  of  his  experience  in  such  mat- 
ters he  is  usually  asked  to  do  so.  This  more  frequently 
occurs  during  a  first  audit  than  thereafter,  because  the  major- 
ity of  business  men  in  deciding  on  an  audit  for  the  first  time 
are  influenced  largely  by  a  feeling  that  an  independent  exam- 
ination of  their  accounts  will  result  in  improved  methods  and 
helpful  suggestions.  It  is  a  not  at  all  undesirable  state  of 
affairs,  but  care  should  be  taken  not  to  promise  too  much.  It 
may  easily  happen  that  a  client,  who  is  given  reason  to  expect 
that  his  expenses  will  be  cut  down  as  a  result  of  an  auditor's 
investigations,  finds  himself  with  a  larger  pay-roll  and  heavier 
expenses  through  the  introduction  of  books  and  methods  which 
are  necessary  to  so  record  the  transactions  that  savings  may 
be  made  in  other  departments;  although  the  ultimate  saving 
may  more  than  offset  the  increased  expenses.  The  bookkeep- 
ing staff  may  object  to  the  audit,  as  they  still  do  in  so  many 
cases  in  the  United  States,  and  it  may  be  hard  for  the  auditor 
to  have  his  suggestions  properly  carried  out.  The  auditor 
cannot  hope  to  be  of  any  permanent  value  unless  he  masters 
the  entire  system  of  accounts  and  by  his  very  knowledge  com- 
pels recognition.  In  this  connection  the  "  entire  system  "  does 
not  mean  merely  the  financial  books  comprising  the  ledgers  and 
the  books  from  which  postings  are  made  thereto,  but  the  sta- 
tistical and  original  entry  books,  such  as  receiving  and  ship- 
ping books  or  records,  salesmen's  orders,  stock  records,  cost 

55 


56  AUDITING. 

accounts,  and  various  other  books  and  records  which,  because 
they  usually  are  not  called  for  by  an  auditor,  receive  scant 
attention  from  others.  The  suggestions  in  the  following  chap- 
ters will,  therefore,  not  be  amiss  in  the  present  connection; 
but  it  will,  of  course,  be  understood  that  the  various  questions 
now  about  to  be  considered  are,  for  the  most  part,  largely  mat- 
ters of  individual  opinion.  The  views  stated  in  the  following 
paragraphs  are  those  of  the  authors,  but  supplemented  by 
various  views  expressed  by  recognized  authorities,  and  it  is  by 
no  means  suggested  that  they  should  all  be  unquestioningly 
taken  on  trust  by  the  readers  of  this  book.  Circumstances 
notoriously  alter  cases,  and  in  no  state  of  existence  is  this 
more  true  than  in  the  realm  of  accounts. 

The  above  remarks  will  serve  to  explain  the  modus  oper- 
andi, not  only  with  regard  to  the  forms  of  accounts  sug- 
gested here  below,  but  also  in  the  following  chapters,  where 
various  important  questions  of  principle  are  considered. 

GENERAL    SYSTEM    OF    INTERNAL    CHECK. 

This  is  a  matter  that  may  very  profitably  engage  the  careful 
attention  of  the  auditor,  for  not  only  will  a  proper  system 
of  internal  check  frequently  obviate  the  necessity  of  a  detailed 
audit,  but  it  further  possesses  the  important  advantage  of  caus- 
ing any  irregularities  to  be  corrected  at  once,  instead  of  con- 
tinuing until  the  next  visit  of  the  auditor,  which — even  m  the 
case  of  a  continuous  audit — is  clearly  a  consideration.  It  is 
very  probable  that  the  auditor  will  be  asked  to  make  any  sug- 
gestions that  may  occur  to  him  for  the  improvement  of  the 
existing  system  of  accounts,  or  in  the  case  of  a  new  under- 
taking he  may  be  invited  to  prepare  a  system  for  the  use  of 
his  clients.  In  the  latter  case  at  least  the  work  is  naturally  no 
part  of  the  regular  audit,  and  should  command  a  special  fee, 
but  in  the  former  case  it  would  not  usually  be  regarded  as  an 
extra  unless  the  alterations  suggested  and  adopted  were  of  a 
radical  nature. 


METHODS  OF  ACCOUNT.  57 

In  devising  any  system  of  internal  check,  there  are  three 
matters  to  be  specially  borne  in  mind:  first,  the  person  in 
charge  of  the  cash  should  never  be  in  charge  of  any  ledger, 
or,  at  least,  of  any  individual  ledger;  secondly,  each  separate 
ledger  should  be  made  self-balancing,  or  at  least  should  be  so 
arranged  that  it  can  be  separately  balanced,  and  where  this  is 
for  any  reason  not  altogether  practicable,  it  is  absolutely  essen- 
tial that  those  ledgers  which  are  not  checked  in  detail  should 
be  so  arranged  that  they  may  be  collectively  balanced  separately 
from  those  ledgers  that  are ;  thirdly,  where  the  individual  led- 
gers are  numerous  and  are  not  checked  in  detail  by  the  auditor, 
the  clerks  in  charge  should  be  frequently  changed  about,  so  that 
if  there  is  any  irregularity  it  is  impossible  for  it  to  remain  long 
undetected  without  implicating  the  whole  staff.  With  a  system 
of  accounts  arranged  upon  these  lines,  a  detailed  audit  is  fre- 
quently not  necessary  in  its  entirety ;  but  it  is  always  desirable 
that  the  auditor  should  satisfy  himself  that  the  system  has 
actually  been  carried  out  as  originally  designed,  and  sections 
of  the  work  should  be  fully  checked  at  unexpected  times. 

INSTRUCTIONS  AS  TO  GENERAL  SYSTEM  OF 
ACCOUNTS. — It  is  sometimes  desirable  that  the  head  book- 
keeper should  be  placed  in  possession  of  written  instructions 
containing  an  outline  of  the  system  to  be  followed.  These 
written  instructions  will  naturally  vary  very  considerably  ac- 
cording to  circumstances,  and  it  is  impossible  to  give  here  more 
than  the  barest  outline  of  what  may  be  required.  The  follow- 
ing points  are,  however,  important  ones,  which  will  generally 
require  to  be  included: — 

(i)  All  cash  received  to  be  paid  into  bank  daily.       The 
cashier  to  have  no  control  over  any  of  the  ledgers. 

(2)  All  payments  other  than  petty  cash  payments  to  be 
made  by  cheque,  whatever  the  amount. 

(3)  The  petty  cash  book  to  be  kept  upon  the  imprest  system 
under  the  supervision  of  the  cashier.     The  clerk  in  charge  of 


58  AUDITING. 

the  petty  cash  must  on  no  account  be  allowed  to  receive  any 
moneys  for  sundry  cash  receipts. 

(4)  Vouchers  to  be  obtained  for  every  payment. 

(5)  The  cash  and  bank  balances  to  be  verified  daily,  and 
the  reconciliation  recorded  in  a  special  balance  book. 

(6)  All  ledgers  to  be  rendered  self -balancing,  and  all  indi- 
vidual ledgers  to  be  balanced  monthly. 

(7)  An  adequate  system  of  stock  accounts  and  cost  accounts 
to  be  provided. 

(8)  All  invoices  for  purchases  to  be  passed  by  the  receiving 
department,  by  the  buyer  of  the  department  concerned,  and  by 
the  accounting  department,  before  being  entered  in  the  pur- 
chases book  or  voucher  record. 

(9)  Statements  for  payments  to  be  passed  by  some  respon- 
sible person,  preferably  one  of  the  partners,  or  the  manager. 

(10)  The  calculations  of  all  sales  to  be  checked  in  the 
accounting  department  before  the  ledgers  are  posted. 

(11)  Each  time  the  sales  ledgers  are  balanced  a  Hst  of  all 

accounts  more  than days  overdue  to  be  submitted  to  the 

head  bookkeeper,  and  by  him  to  one  of  the  principals   for 
further  instructions. 

(12)  A  thoroughly  efficient  system  of  calculating  and  pay- 
ing wages  to  be  introduced,  and  closely  adhered  to. 

(13)  So  far  as  may  be  possible,  the  duties  of  every  member 
of  the  staff  should  be  varied  from  time  to  time. 

(14)  Every  member  of  the  staff  should  be  required  to  take 
a  vacation  at  least  once  a  year. 

(15)  No  member  of  the  staff  should  be  allowed  to  perform 
what  are  (for  the  time  being)  the  duties  of  another. 

(16)  The  minute  books  to  be  fully  entered  up,  and  kept 
indexed  to  date. 


METHODS  OF  ACCOUNT.  59 

(17)  All  exceptional  transactions  to  be  reported  to  the 
board  at  the  next  meeting  for  approval  or  further  instructions. 

(18)  The  various  books  required  by  the  State  laws  to  be 
kept  written  up,  and  the  necessary  returns  to  be  made  to  the 
proper  officers  from  time  to  time. 

COST   ACCOUNTS. 

Every  system  of  bookkeeping,  worthy  of  the  name,  that 
purports  to  record  the  transactions  of  a  manufacturer,  will 
provide  some  method  of  ascertaining  the  cost  of  the  articles 
produced,  while  many  systems  recording  transactions  of  a 
purely  trading  nature  (i.  e.,  buying  and  selling  ow/y)  will  like- 
wise find  a  proper  system  of  costing  most  advantageous.  This 
branch  of  an  auditor's  work  has  received  more  attention  in  the 
last  few  years  than  in  the  previous  twenty,  and  it  is  believed 
that  in  the  United  States  at  least  a  very  considerable  advance 
has  been  made,  although  those  giving  the  matter  serious  atten- 
tion form  a  small  minority. 

It  is  not  considered  practicable  to  treat  of  this  subject  in 
a  treatise  on  auditing,  but  the  importance  of  proper  cost  ac- 
counts can  hardly  be  overestimated,  and  should  be  emphasized 
whenever  an  opportunity  affords. 

There  does  not  seem  to  be  any  logical  reason  for  the  general 
practitioner  to  feel  that  cost  accounting  is  so  complicated  that 
be  had  better  keep  his  hands  off,  thus  opening  the  way  for  the 
so-called  cost-specialist. 

The  results  of  the  latter's  work  have  not  always  been 
happy;  in  numerous  instances  where  an  elaborate  cost  system 
has  been  installed,  without  regard  to  the  commercial  or  general 
system  of  accounts,  the  results  of  the  business,  as  actually 
stated  in  the  latter,  are  so  at  variance  with  the  results  produced 
by  the  cost  books  as  to  give  rise  to  well  deserved  criticism. 

A  sane  system  of  cost  accounts  necessarily  works  harmo- 
niously with  and  directly  into  the  commercial  books,  and  the 


60  AUDITING. 

proper  person  to  bring  about  this  result  is  the  auditor,  whose 
experience  is  general,  rather  than  one  whose  vision  is  limited. 

The  most  absurd  development  of  the  recent  agitation,  how- 
ever, is  the  stationery  house  which  manufactures  ready-made 
"  systems  "  in  its  factory,  and  "  guarantees  "  the  wildest  results 
— such  as  a  daily  balance  sheet  and  profit  and  loss  account. 
All  you  have  to  do  is  to  make  over  your  whole  business 
methods  to  suit  their  printed  forms  and  they  will  do  the  rest 
(provided,  of  course,  you  buy  all  your  stationery  from  them!) 

The  auditor  should  bear  in  mind  that  books  are  intended 
to  record  business  transactions  and  the  results  thereof ;  there- 
fore it  is  essential  that  the  system  of  accounting  should  be 
adapted  to  the  needs  of  the  business,  and  not  the  business 
made  to  fit  some  cut  and  dried  accounting  system. 

The  literature  upon  the  subject  of  cost  accounting  is  improv- 
ing in  quantity  and  quality  so  rapidly  that  it  is  not  considered 
advisable  to  draw  attention  to  any  particular  books,  but  rather 
to  advise  the  reader  to  make  his  investigations  as  wide  as 
possible. 

FORM    OF    CASH    BOOK. 

A  good  form  of  cash  book  not  only  saves  time  and  trouble 
every  day  of  the  year,  but  also — to  an  even  greater  extent — 
when  the  ledgers  come  to  be  balanced. 

It  is  impossible  to  go  fully  into  this  matter  here,  but  it  is 
suggested  that,  in  all  businesses  of  any  magnitude,  the  auditor 
should  consider  the  advisability  of  recommending  the  introduc- 
tion of  various  columns  into  the  cash  book  that  would  facilitate 
the  balancing  of  the  various  ledgers  employed.  In  an  extreme 
case,  the  use  of  a  ledger  might  be  almost  obviated  by  the  use 
of  a  numerous  columned  cash  book ;  and  in  many  cases  a  little 
ingenuity  will  suffice  to  materially  reduce  the  labor  of  posting 
during  the  year  and  to  a  corresponding  extent  facilitate  the 
balancing  of  the  ledgers  at  the  end  of  the  fiscal  year. 


METHODS  OF  ACCOUNT.  6l 

In  large  concerns  a  great  saving  of  time  may  be  effected 
by  assigning  a  separate  cash  book  to  each  ledger  clerk.  These 
separate  cash  books  will,  of  course,  all  work  into  the  general 
cash  book.  (See  further,  under  "  Self-balancing  Ledgers," 
posiea.) 

DISCOUNT   AND    INTEREST. 

A  considerable  amount  of  time  may  be  saved  by  a  proper 
system  in  recording  cash  discounts.  Every  trading  or  manu- 
facturing concern  should  have  discount  columns  in  its  cash 
book;  by  which  means  the  necessary  number  of  postings  may 
be  considerably  reduced.  The  common  practice  of  posting 
the  total  of  the  debit  discount  column  to  the  debit  of  the 
ledger,  and  vice  versa,  is,  however,  condemned  by  some  author- 
ities as  unscientific.  They  claim  that  an  entry  should  be  made 
at  the  foot  of  the  debit  column  for  the  total  amount  of  dis- 
counts received,  and  posted  thence  to  the  credit  of  the  dis- 
count account;  while  on  the  credit  side  of  the  cash  book  an 
entry  is  made  in  the  discount  column  of  the  total  amount  of 
discounts  allowed,  which  is  posted  to  the  debit  of  the  discount 
account.  By  this  means  the  total  of  the  debit  and  credit  dis- 
count columns  will  be  made  to  agree,  while  the  advantage  of 
posting  totals  to  the  ledger  account  instead  of  differences,  is 
not  lost.  Moreover  the  rule  that  the  debit  cash  entries  arc 
posted  to  the  credit  of  the  ledger,  and  vice  versa,  is  uniformly 
maintained,  which  will  always  be  an  advantage  theoretically, 
and — where  one  is  dealing  with  second-rate  bookkeepers — 
practically  as  well. 

In  every  case  the  total  of  discounts  received  should  be  cred- 
ited to  a  properly  named  profit  and  loss  account,  and  the  total 
of  discounts  allowed  debited.  A  further  consideration  arises, 
however — ^namely,  that,  while  discounts  are  theoretically  sup- 
posed to  represent  an  allowance  granted  for  a  payment  made 
before  it  is  due,  it  is  an  almost  universal  custom  to  deduct 
discount  from  all  outstanding  accounts  at  balancing  time,  and 
to  amend  the  profit  and  loss  account  accordingly.     The  posi- 


62  AUDITING. 

tion  is  not  very  logical;  but  where,  upon  the  whole,  discounts 
show  a  loss,  there  is  much  to  commend  it. 

Discounts  allowed  for  prompt  or  anticipated  cash  payments 
must  not  be  confounded  with  trade  discounts.  Many  book- 
keepers confuse  the  two,  and  it  is  therefore  necessary,  in  many 
cases,  for  the  auditor  to  analyze  the  Interest  and  Discount 
Account  in  the  ledger. 

There  should,  however,  be  little  difficulty  in  distinguishing 
between  cash  and  trade  discounts ;  wherever  the  rate  is  higher 
than  that  which  an  ordinary  concern  would  usually  pay  for 
the  convenience  of  prompt  payments  it  can  safely  be  treated 
as  a  trade  discount,  and  the  amount  so  received  should  be  ap- 
plied in  reduction  of  the  cost  of  the  goods  purchased. 

Cash  Discounts  (so-called)  received  on  account  of  capital 
expenditure  are  clearly  a  reduction  of  such  capital  expenditure. 

INTEREST,  received  and  allowed,  requires  to  be  separated 
in  the  profit  and  loss  account,  just  the  same  as  discount;  and, 
where  it  is  desired  to  reveal  the  whole  effect  of  the  working  of 
a  concern,  it  is  advisable  to  separate  discount  from  interest. 

The  question  of  outstanding  discount  and  interest  is  dealt 
with  more   fully  in  Chapter  VI . 

BANK  CHARGES.— Before  taking  leave  of  the  cash  book, 
it  is  well  to  note  that  the  auditor  might  with  advantage  roughly 
check  the  bank  charges  debited  to  his  client,  and  see  that  the 
rate  actually  charged  is  in  accordance  with  arrangements  made. 

PETTY    CASH. 

The  author  is  acquainted  with  two  good  systems  of  petty 
cash,  and  with  numerous  bad  ones.  It  is  not  proposed  to 
deal  exhaustively  with  the  latter,  but  a  good  system  is  suffi- 
ciently uncommon  to  merit  a  record  in  these  columns. 

The  system  of  debiting  petty  cash  payments  en  bloc  to  ex- 
penses is  bad ;  and  it  is  therefore  assumed  that,  under  each  of 


METHODS  OF  ACCOUNT.  63 

the  following  methods,  the  various  payments  are  periodically- 
analyzed.  The  petty  cash  book  should  be  ruled  and  balanced 
at  least  once  a  month,  and  frequently  it  will  be  found  advan- 
tageous to  balance  at  even  shorter  intervals.  The  analysis 
may  be  made  either  by  means  of  analysis  columns  in  the  book 
itself  or  by  a  summary  written  in  the  book  after  being  pre- 
pared on  loose  dissecting  sheets,  as  may  be  found  most  con- 
venient. 

Under  one  system  the  petty  cashier  is  started  with  an 
amount,  say  $100.00,  which  is  supposed  to  be  more  than  suffi- 
cient for  the  payments  for  the  month  (or  whatever  other 
period  be  adopted).  At  the  end  of  the  month  he  hands  the 
cashier  a  summary  of  his  payments,  and  receives  a  cheque 
for  that  amount.  On  the  stub  of  the  cheque  the  summary 
(or  a  reference  to  it)  is  written,  and  the  cheque  is  written  up 
in  detail  in  the  cash  book  at  once,  and  thence  posted  direct 
to  the  debit  of  the  various  accounts.  Under  this  system  no 
ledger  account  is  required  for  petty  cash,  but  an  account 
should  in  every  case  be  opened  for  the  initial  balance,  as,  if  it 
be  left  as  a  floating  balance  on  Office  Expenses,  or  any  other 
nominal  account,  it  is  apt  to  get  lost  sight  of.  The  chief 
cashier  should  thoroughly  examine  the  petty  cash  book  each 
time  he  draws  a  cheque ;  and  when  the  cheque  has  been  cashed, 
the  initial  balance  should  be  shown  him  intact.  The  auditor 
also  will,  of  course,  require  to  see  this  balance,  or  to  have  it 
properly  accounted  for. 

In  some  instances  where  vouchers  are  required  for  all  petty 
cash  payments,  a  loose  summary  sheet  is  used  to  which  the 
vouchers  are  attached  and  on  which  they  are  entered  in  detail. 
This  system  does  away  entirely  with  the  petty  cash  book. 

The  other  system  is  more  suitable  where  the  expenditure 
is  too  large  for  it  to  be  deemed  desirable  to  trust  the  petty 
cashier  with  an  amount  sufficient  to  cover  a  month's  expenses. 

In  this  case,  there  will  be  a  small  initial  balance,  and  when 
it  becomes  nearly  exhausted  a  cheque  will  be  given  for  the 


64  AUDITING. 

exact  amount  spent  up  to  date.  This  system  is  thus  similar  to 
the  former,  but  with  shorter  rests;  but  to  avoid  numerous 
entries  in  the  cash  book  the  cheques  drawn  (including  that 
for  the  initial  balance)  are  posted  to  the  debit  of  a  Petty  Cash 
Account  in  the  ledger.  The  result  of  the  monthly  summary  is 
credited  to  Petty  Cash  Account  and  debited  to  the  various 
nominal  accounts,  either  by  being  posted  direct  from  the  sum- 
mary or  by  means  of  a  journal  entry.  The  balance  of  the 
Petty  Cash  Account  at  the  end  of  each  month  will  thus  always 
represent  the  amount  of  the  initial  balance. 

It  will  be  noticed  that  debiting  nominal  accounts  has  always 
been  spoken  of.  In  the  comparatively  rare  cases  where  it  is 
desirable  to  make  purchase  ledger  and  other  payments  (which 
involve  the  debit  of  a  personal  account)  by  cash,  every  consid- 
eration of  convenience  will  tend  to  the  use  of  a  separate  cash 
book  for  this  purpose,  which  will,  of  course,  be  kept  upon 
similar  lines  to  those  indicated.  Sometimes  (as  in  the  case  of 
lawyers)  it  is  better  to  keep  only  one  petty  cash  book,  but  in 
that  case  separate  columns  should  be  employed  for  expenses 
and  for  payments  on  account  of  clients. 

Both  the  above  are  varieties  of  the  "  Imprest  System,"  so 
called  from  the  demand  (or  imprest)  presented  to  the  chief 
by  the  petty  cashier  from  time  to  time  for  a  sum  to  reimburse 
him  for  his  payments. 

A  good  system  of  petty  cash  is  of  the  greatest  value,  both  to 
the  auditor  and  to  his  clients,  and  it  is  therefore  always  advis- 
able that  the  auditor  should  use  his  influence  in  this  direction. 

RENTS    (RECEIVED    AND    PAID). 

Where  a  considerable  portion  of  the  income  is  derived  from 
the  receipt  of  Rents  it  is  probable  that  some  reasonable  system 
of  accounts  will  be  found  in  connection  with  them ;  but  where 
the  matter  is,  so  to  speak,  a  side-issue,  the  probabilities  are 
that  there  will  be  found  to  be  no  system  whatever.    Cottages 


METHODS  OF  ACCOUNT.  6$ 

let  to  workmen  are,  perhaps,  the  most  ordinary  instance  of  a 
revenue  being  incidentally  derived  from  rents  received;  and, 
as  a  rule,  the  accounts  in  connection  with  them  will  be  found 
extremely  primitive.  The  usual  method  is  to  deduct  the 
amount  of  rent  from  each  man's  pay,  and  credit  the  total  de- 
ductions to  a  Rent  Received  Account.  This  method  might 
answer  if  the  proper  deductions  were  invariably  made;  but 
under  such  a  system — if  a  man  were  allowed  to  get  into  arrears, 
or  if  no  wages  were  due  to  him — the  matter  is  very  liable  to  be 
lost  sight  of;  and,  in  any  case,  no  proper  record  will  be  kept 
of  any  allowances  made  to  tenants  for  taxes,  repairs,  &c.  In 
every  case,  therefore,  a  proper  rent-roll  should  be  kept.  In 
general,  this  will  be  found  an  actual  saving  of  time  in  the  end ; 
and,  in  any  case,  it  will  probably  save  its  cost  in  the  increasing 
resultant  revenue. 

Suitable  rulings  for  rent-rolls  (for  rents  payable  weekly, 
monthly,  &c.)  will  be  found  in  the  author's  "Auctioneers'  Ac- 
counts." 

The  proportion  of  rent  accrued,  but  not  due,  should  be  in- 
cluded in  the  balance  sheet  as  an  asset;  as  also  should  all 
arrears,  unless,  indeed,  there  is  reason  to  believe  that  they 
will  not  be  recovered.  All  accrued  and  outstanding  liabilities 
for  ground  rent,  rates,  taxes,  &c.,  must  also  be  included,  and 
the  auditor  must  not  be  put  off  with  any  suggestion  that 
"  they  about  balance  one  another."  What  he  has  to  deal  with 
are  the  facts. 

In  the  case  of  cottage  property,  occupied  by  workmen,  it  is 
desirable  to  show  the  whole  matter  in  a  nutshell  in  the  profit 
and  loss  account;  therefore  show  rents,  less  expenses,  on  the 
credit  side,  and  carry  out  only  the  net  revenue  derived. 

Where  only  a  portion  of  certain  premises  is  occupied,  and 
the  remainder  sub-let,  a  similar  course  should  be  pursued. 
That  is  to  say,  the  total  rent  paid  should  be  shown  on  the  debit 
side,  the  rent  receivable  deducted,  and  the  net  rent  paid  carried 
out.     It  is  considered  in  some  quarters  that  a  statement  of  the 


66  AUDITING. 

net  amount  is  sufficient ;  but  the  effect  of  the  sub-let  premises 
becoming  vacant  should  be  considered,  for  if  this  be  ne- 
glected, the  amount  stated  in  the  accounts  would  be  liable  to 
sudden  and  unexplained  fluctuations.  If  accounts  are  intended 
to  show  the  whole  facts  of  the  case,  it  will  be  seen  at  once  how 
defective  are  statements  containing  the  net  amount  only. 

RENTS  PAYABLE. — Where  the  business  is  carried  on  in 
premises  owned  by  the  proprietors  and  there  are  other  tenants 
there  is  no  reason  why  the  rent  account  should  not  be  charged 
with  a  fair  amount  for  the  use  of  the  premises.  This  prac- 
tically amounts  to  the  proprietors  giving  themselves  a  lease 
of  the  property,  which  naturally  leads  to  a  consideration  of  the 
question  of  leaseholds. 

WHERE  A  VALUABLE  LEASE  is  held,  for  which  a  pre- 
mium has  been  paid,  the  annual  amount  written  off  for  de- 
preciation may  appropriately  be  charged  to  rent  account,  it 
being  in  fact  merely  a  portion  of  the  rent  paid  in  advance; 
but  it  would  be  well  for  the  accounts  to  state  that  this  has  been 
done. 

"SELF-BALANCING"    LEDGERS. 

All  accountants — and,  for  that  matter,  most  bookkeepers — 
will  be  familiar  with  the  method  usually  adopted  for  verifying 
the  accuracy  of  each  ledger  in  a  system  of  accounts.  It 
would  probably  be  the  exception  to  find  a  set  of  books  in  which 
some  device  for  the  separate  balancing  of  each  ledger  was  not 
in  use ;  although  the  system  of  applying  this  check  is  not  always 
properly  organized. 

When  the  latter  is  the  case  the  usual  method  is  to  take  the 
total  of  the  list  of  ledger  balances  at  the  previous  time  of  bal- 
ancing, allow  for  the  total  amounts  that  should  have  been 
posted  to  the  debit  and  credit  of  the  ledger  respectively,  and  the 
resultant  figure  should  agree  with  the  total  of  the  present  list 
of  balances.  This  method  is  often  of  the  greatest  possible 
assistance  when  dealing  with  books  that  have  been  more  or  less 


METHODS  OF  ACCOUNT.  6/ 

incompletely  kept ;  but  it  can  hardly  be  called  scientific,  and  is, 
at  best,  but  a  convenient  makeshift. 

The  general  ledger  should  contain  a  controlling  account  for 
each  of  the  subsidiary  ledgers,  and  in  some  instances,  e.  g., 
ledgers  at  branch  houses  or  at  works  offices,  it  may  be  found 
desirable  to  have  a  complement  of  the  controlling  account  in 
the  subsidiary  ledger,  but  in  the  case  of  ledgers  for  accounts 
receivable,  &c.,  which  are  kept  in  the  same  office  as  the  general 
or  private  ledger,  it  is  not,  as  a  rule,  necessary  to  have  the  con- 
trolling account  appear  in  both  ledgers.  The  detailed  consid- 
eration of  this  matter  is,  however,  a  question  of  bookkeeping 
rather  than  auditing;  it  will  accordingly  be  found  to  be  fully 
dealt  with  in  the  author's  "  Bookkeeping  for  Accountant  Stu- 
dents." The  controlling  account  is  a  most  valuable  device,  as 
by  this  means  each  ledger  can,  at  any  time,  be  balanced  with  the 
minimum  of  trouble,  and  independently  of  the  other  ledgers. 
Hence  it  follows  that  a  rough  balance  sheet  and  profit  and  loss 
account  can  always  be  prepared  in  a  very  short  space  of  time, 
without  involving  the  labor  of  balancing  every  ledger.  Again, 
the  clerk  keeping  the  general  ledger  (naturally  the  clerk  most 
to  be  trusted,  if  not  actually  one  of  the  principals,  or  perhaps, 
even  the  auditors  themselves)  has  a  very  good  check  on  every 
other  ledger  clerk.  It  must,  however,  never  he  lost  sight  of 
that  the  only  reliable  verification  of  the  various  balances  of  the 
controlling  accounts  in  the  general  ledger  lies  in  the  thorough 
verification  of  the  various  suhsidia/ry  ledger  balances.  If  this 
fact  be  lost  sight  of,  there  is  a  serious  risk  of  fraud;  but,  if 
the  system  be  intelligently  applied,  it  is  a  distinct  preventive 
of  any  kind  of  irregularity. 

The  auditor  who  once  adopts  this  system  will  find  it  not 
only  lessens  his  own  work  and  that  of  the  bookkeeper,  but  also 
adds  to  the  completeness  of  whatever  system  may  have  previ- 
ously been  in  use ;  and,  further,  materially  increases  the  pleas- 
ure attendant  upon  the  investigation.  Where  the  auditor 
himself  keeps  the  private  ledger  (a  not  uncommon  practice 
where  private  persons  and  firms  are  concerned)  the  advantage 


68  AUDITING. 

of  making  each  ledger  "  self-balancing  "  must  be  sufficiently 
obvious  to  need  no  further  demonstration. 

Where  proper  stock  accounts  are  kept,  or  there  is  a  reliable 
means  of  estimating  the  amount  of  stock  on  hand  (cf.  Stock 
Accounts),  the  existence  of  self-balancing  ledgers  makes  it 
possible  for  a  reliable  balance  sheet  and  profit  and  loss  account 
to  be  prepared,  at  any  time,  in  a  few  hours ;  and  the  advantage 
of  this — where  no  cost  accounts  can  be  kept — is  hardly  to  be 
over-estimated. 

TABULAR  LEDGERS.— Another  form  of  self-balancing 
ledger — to  which  indeed  the  term  "  self-balancing  "  may,  per- 
haps, be  more  appropriately  applied  than  to  the  kind  described 
in  the  preceding  paragraph — is  the  tabular  ledger.  This 
ledger  is  suitable  to  those  concerns  in  which  accounts  are 
rendered  only  at  certain  definite  intervals,  and  where  the  num- 
ber of  customers  is  extremely  numerous,  while  the  number  of 
transactions  with  each  customer  is  but  small.  These  limita- 
tions naturally  reduce  the  general  utility  of  tabular  ledgers, 
but  they  are  common  with  gas  companies,  water  companies, 
electric  light  companies,  and  also  for  the  purpose  of  recording 
the  collection  of  taxes  made  by  various  governmental  bodies. 
In  each  of  these  cases  the  account  rendered  to  the -customer 
virtually  consists  of  a  single  item,  but  the  same  form  of  ledger 
is  sometimes  found  convenient  in  cases  where  a  large  number 
of  items  have  to  be  recorded;  in  these  latter  cases,  however, 
a  subsidiary  ledger  has  to  be  kept  for  the  purpose  of  collect- 
ing the  items  which  constitute  the  account  to  be  collected. 
Under  ordinary  circumstances  the  extra  labor  involved  would 
go  far  to  prevent  the  employment  of  tabulated  ledgers  in  such 
cases  as  this,  but  it  sometimes  occurs — e.  g.,  in  the  case  of  a 
mine — that  the  daily  deliveries  are  only  invoiced  as  regards 
weight  and  quality,  without  being  priced  out,  and  that  the  sub- 
sidiary ledger  is  also  kept  in  quantities  only;  the  pricing  out 
being  only  done  when  the  monthly  statement  of  account  is  sent 
in,  and  this  being  so,  a  tabulated  form  of  ledger  might  con- 
veniently be  adopted  in  such  a  case,  although  probably  the 


METHODS  OF  ACCOUNT.  69 

number  of  accounts  would  not  be  sufficient  to  render  such  a 
course  imperative. 

In  undertakings  with  numerous  branches  or  mines  it  has 
been  found  very  convenient  to  use  tabular  operating  ledgers 
for  the  various  nominal  accounts,  such  as  labor,  &c. 

Instead  of  having  a  separate  ledger  account  for  the  operat- 
ing accounts  (and  property  accounts,  too,  for  that  matter),  of 
each  mine,  columns  are  provided  for  all  under  the  one  heading ; 
a  total  column  being  used  for  the  general  trial  balance  or 
balance  sheet.  This  system  reduces  the  number  of  postings, 
pagings  and  labor  generally,  and  makes  comparisons  and  state- 
ments easy. 

Yet  another  form  of  tabular  ledger  is  that  in  general  use 
at  hotels.  The  especial  object  of  this  form  is  to  make  the 
ledger  do  duty  not  only  as  a  personal  ledger,  showing  the 
state  of  account  between  the  hotel  and  the  various  visitors,  but 
also  as  a  nominal  ledger,  showing  the  analyzed  receipts  from 
day  to  day.  This  form  of  ledger  is  especially  applicable  to 
hotels,  on  account  of  the  large  number  of  nominal  accoimts 
employed  to  analyze  the  income  derived  from  various  sources ; 
it  is  also  most  convenient  on  account  of  the  fact  that  it  pre- 
sents the  readiest  means  of  keeping  each  account  written  up 
to  date,  with  a  minimum  of  labor. 

It  is  a  question,  however,  as  to  whether  it  would  not  be  a 
saving  of  time  and  insure  more  accurate  results  to  abandon 
the  analyses  in  the  ledger  and  cash  book  and  depend  upon 
the  footings  of  the  original  records  from  which  the  ledger  is 
posted.  The  ordinary  hotel  cashier  is  extremely  careless  about 
the  distribution  of  receipts,  and  as  he  usually  works  "  on  the 
jump,"  there  is  much  to  excuse  him.  It  is  quite  feasible  to 
have  the  various  records  from  which  the  postings  are  made — 
e.  g.,  restaurant,  laundry,  service  to  room,  livery,  baggage  and 
other  charges — either  footed  in  the  books  themselves  or  sum- 
marized on  sheets  ruled  for  the  purpose.  The  cashier  by  this 
method  need  not,  of  course,  analyze  his  receipts,  while  at  the 
«ame  time  accurate  results  are  obtained. 


70  AUDITING. 

LOOSE    LEAF    AND    CARD    BOOKKEEPING,    CBl,c. 

Of  late  years  the  loose  leaf  and  card  systems  of  bookkeep- 
ing have  been  steadily  advancing  in  favor,  and  there  seems 
to  be  every  indication  that  as  their  advantages  become  more 
widely  known  they  will  be  still  further  utilized.  A  full  descrip- 
tion of  the  various  applications  of  these  systems  will  be  found 
in  the  author's  "Advanced  Accounting,"  and  would  be  out 
of  place  here.  It  is  necessary,  however,  for  the  sake  of  com- 
pleteness, to  now  consider  the  matter  from  the  point  of  view 
of  the  auditor.  There  can  be  no  doubt  but  that,  unless  a  thor- 
oughly efficient  system  of  account-keeping  prevails,  the  intro- 
duction in  any  form  whatever  of  the  loose  leaf  system  is  likely 
to  make  confusion  worse  confounded;  but,  given  a  properly 
organized  accounting  department,  it  seems  that  practically  the 
only  drawback  that  can  be  suggested  is  the  increased  responsi- 
bility that  is  thrown  upon  the  auditor  of  maintaining  a  vigilant 
outlook  for  fraud. 

A  great  deal  has  been  made  by  some  critics  of  the  possi- 
bility of  cards,  or  sheets,  being  destroyed,  and  replaced  by 
others  containing  falsified  entries.  With  a  proper  system, 
however,  such  irregularities  would  be  more  speedily  detected 
than  would  their  equivalent  under  the  old-fashioned  system 
of  recording  all  entries  in  bound  books.  Bound  books  are  in- 
variably paged  or  folioed  consecutively,  but  it  is  safe  to  assert 
that  no  auditor  ever  conceived  it  to  be  part  of  his  duty  to 
make  sure  that  the  pages  or  folios  of  each  ledger  were  com- 
plete. If  a  folio  be  neatly  extracted  from  a  ledger,  it  is  not 
unlikely  that  its  absence  might  remain  undetected  for  months, 
so  long  as  it  had  not  been  removed  until  after  all  postings 
to  that  folio  had  been  checked. 

With  both  card  and  loose  leaf  ledgers  it  is  as  a  rule  better 
to  check  the  postings  by  calling  back  from  the  ledger  into 
the  books  of  first-entry,  as  time  can  generally  thus  be  saved; 
while  this  sequence  enables  the  auditor  to  more  readily  satisfy 
himself  that  the  ledger,  as  presented  to  him  for  audit,  is 
complete. 


METHODS  OF  ACCOUNT.  7I 

It  is  needless  to  say  that  the  loose  leaf  system  is  not  adapted 
to  every  business  regardless  of  any  peculiar  conditions  which 
may  exist.  It  is  true  that  some  stationery  houses  claim  that 
they  can  install  a  system  suitable  for  any  business  whereby 
loose  leaves  and  cards  can  be  substituted  for  every  bound 
book  in  use,  but  in  numerous  instances  where  this  has  been 
done  the  result  has  not  borne  out  the  expectation,  and  it 
simply  adds  further  proof  of  their  inability  to  displace  the 
professional  auditor. 

STORES    AND    STOCK    ACCOUNTS. 

In  many  businesses  it  is  quite  practicable  to  keep  a  reliable 
record  of  all  goods  or  stores  in  stock,  and — wherever  this  is 
possible — it  is  clearly  desirable  that  the  auditor  should  place 
before  his  clients  the  indisputable  advantages  of  such  a  course. 

Full  details  as  to  the  best  method  to  be  adopted  in  all  cases 
would  naturally  involve  a  consideration  of  the  particular  stocks 
employed  in  various  trades  and  manufactures,  and  would  be 
out  of  place  in  this  volume,  but  the  following  general  recom- 
mendations (quoted  from  "The  Accountants'  Manual,"  Vol. 
II)  will  doubtless  prove  sufficient  for  the  purpose: — 

(i)  Debit  and  credit  accounts  should  be  opened,  as  far  as 
possible,  for  each  description  of  stores  used.  On  one  side 
of  the  accounts  the  receipts  would  be  entered,  showing  the 
date,  weight,  quantity  or  number,  and  other  particulars ;  and, 
on  the  other  side,  the  stores  issued  from  time  to  time  woujd 
be  entered,  with  such  particulars  as  were  necessary  or  suitable, 
the  difference  representing  what  ought  to  be  in  hand,  or  there- 
abouts— as,  in  accounts  of  this  kind,  the  balance  shown  upon 
the  accounts  can  hardly  be  depended  upon  exactly. 

(2)  It  is  the  opinion  of  practical  mill-owners  and  managers 
that  in  many  cases  a  really  efficient  and  exact  check  on  stores 
is  not  practicable.  It  could,  no  doubt,  be  devised;  but  the 
detailed  work  in  connection  with  it,  and  consequent  labor  and 
expense,  put  it  out  of  the  range  of  every-day  business,  what- 


72  AUDITING. 

ever  theorists  may  say.  But  many  useful  rules  may  be  laid 
down  preventive  of  fraud  and  waste,  amongst  others  the  fol- 
lowing, taken  from  actual  experience: — 

(a)  Where  stores  are  distributed  for  use  upon  a  specific 
job,  the  job  should  be  stated,  with  the  weight,  quantity,  &c. 

(b)  If  material  of  the  same  kind  is  distributed  to  various 
men  for  the  same  purpose,  a  comparison  should  be  made  be- 
tween the  results  produced  by  each.  If  discrepancies  are 
found,  inquiries  should  be  made,  and  doubtless  in  some  cases 
a  good  explanation  could  be  given :  e.  g.,  use  of  old  machinery 
or  appliances,  &c. 

(c)  The  store  room  should  be  situated  in  a  convenient  place, 
and  be  in  charge  of  a  competent  man  who  combines  practical 
knowledge  of  the  stores  with  sufficient  bookkeeping  experi- 
ence to  appreciate  the  importance  of  account  keeping. 

(d)  The  principal,  or  manager,  should  make  a  point  of  ex- 
amining at  times  the  stock  ledgers  and  exercising  general 
supervision  of  the  department.  Frequent  and  imnotified  visits 
should  be  made,  and  the  storekeeper,  if  possible  (it  is  not  al- 
ways possible),  changed  (occasionally). 

(e)  Some  kinds  of  stores  should  never  be  given  out  unless 
the  used-up  stores  are  returned.  For  example,  a  workman 
making  requisitions  for  files,  brushes,  and  like  things,  should 
only  be  supplied  on  his  giving  up  the  old  articles.  This  is  a 
very  good  check,  when  the  nature  of  the  stores  will  allow  of 
its  application. 

It  will  be  perceived  that  the  above  considerations  refer  pri- 
marily to  the  stores  purchased  by  factories  for  their  own  use ; 
an  ordinary  amount  of  intelligence  will,  however,  suffice  to 
render  the  recommendations  there  made  applicable  to  a  trad- 
ing concern — that  is  to  say,  a  concern  where  the  goods  pur- 
chased are  issued  (sold)  to  outside  persons.  A  simple  system 
will  be  found  described  in  the  author's  "Advanced  Ac- 
counting." 


METHODS  OF  ACCOUNT.  73 

In  designing  stock  accounts  for  trading  concerns  (and  some- 
times, also,  with  factories)  it  is  preferable  to  arrange  for  the 
keeping  of  the  accounts  in  values  as  well  as  in  weight  or 
quantity;  and,  where  this  can  be  done,  it  is  clearly  desirable 
— ^as  it  is  then  possible — ^to  make  the  stock  accounts  part  of 
the  regular  system  of  double-entry  bookeeping  employed.  It 
is,  however,  best  to  retain  the  record  of  weights  or  quantities 
wherever  practicable,  as  otherwise  a  discrepancy  in  quantity 
might  easily  be  concealed  by  an  error  in  the  values  attached 
to  the  various  stores. 

TRADERS'     ACCOUNTS. 

With  some  businesses  (especially  traders  dealing  in  small 
articles  broken  from  bulk)  a  regular  system  of  stock  accounts 
is  not  practicable.  In  such  cases  a  different  method  of  check 
must  be  employed.  In  every  trade  there  is  a  well-known  per- 
centage of  gross  profit  that  ought  always  to  be  earned,  and 
can  rarely  be  exceeded.  If,  therefore,  the  stock  account  is 
started  with  the  actual  stock  on  hand  at  the  commencement  of 
a  period,  debited  from  time  to  time  (usually  monthly)  with 
the  total  purchases,  and  also  with  the  aforementioned  esti- 
mated gross  profits  on  the  sales,  and  credited  with  the  sales; 
the  balance  shown  will  represent  the  stock  on  hand — estimated 
on  the  assumption  that  the  nominal  gross  profit  has  been  ex- 
actly earned.  The  same  result  would  also  be  accomplished  by 
crediting  the  stock  account  with  the  sales  after  deducting  the 
gross  profit  therefrom,  rather  than  debiting  the  gross  profit 
and  crediting  the  sales.  At  the  periodical  stock-taking  this 
estimate  can,  of  course,  be  easily  verified,  or  corrected.  Where 
an  undertaking  trades  in  various  kinds  of  goods,  it  is  always 
desirable  to  dissect  the  sales  and  purchases,  so  that  the  position 
of  the  various  departments  may  be  readily  perceived. 

This  system  is  in  very  general  use,  and  serves  two  miost 
useful  ends,  (i)  It  calls  attention  to  any  discrepancy  between 
the  actual  and  nominal  gross  profits,  by  means  of  a  similar 
discrepancy  between  the  ascertained  and  estimated  stock  in 


74  AUDITING. 

hand.  (2)  It  affords  most  useful  information  as  to  the  prob- 
able amount  of  stock  in  each  department  from  month  to  month, 
and  so  serves  as  a  guide  to,  and  a  check  upon,  the  various  de- 
partmental managers,  as  well  as  affording  material  for  an  in- 
terim balance  sheet,  if  one  be  required. 

*  It  is,  of  course,  impossible  to  give  any  definite  information 
concerning  the  gross  profits  usually  made  in  various  retail 
trades.  Naturally,  everything  depends  upon  the  situation  of 
the  store,  and  the  class  of  business  done.  Variations  are  so 
great  in  different  parts  of  the  United  States  that  it  is  not 
deemed  wise  to  attempt  the  publication  of  even  approximate 
figures.  It  is  suggested,  however,  that  any  auditor  would 
find  a  table  compiled  from  his  own  experience  of  great  value. 

*^  It  is,  perhaps,  well  to  note  that,  in  accordance  with  the  in- 
variable custom  of  traders,  percentages  of  gross  profits  are 
based  upon  the  selling  price  of  the  goods,  and  not  on  the  cost 
price. 

It  may  be  added  that  a  comparison  of  the  ratio  between  the 
stock-in-trade  and  the  sales  during  corresponding  periods  is 
often  useful  as  a  rough  test  of  the  accuracy  of  the  stock-taking. 

Another  system  is  in  use  in  some  large  department  stores 
where  a  more  accurate  check  on  the  various  departments  is 
desired.  All  goods  are  charged  to  departments  at  the  selling 
price,  which,  of  course,  has  been  determined  in  advance;  all 
changes  in  values,  &c.,  are  recorded,  and  at  stock-taking  time 
the  inventory  is  priced,  not  only  at  cost  for  the  private  ofiice 
but  also  at  selling  price  for  the  purpose  of  verification,  and 
the  account  is  supposed  to  balance  exactly.  It  is  surprising 
to  find  how  small  the  discrepancies  may  be  in  houses  trans- 
acting a  large  volume  of  business. 

This  system  can  be  extended  with  advantage  to  other  lines 
of  trade,  as,  for  instance,  retail  branch  stores  selling  cigars, 
groceries,  men's  furnishing  goods,  &c. 

In  conclusion,  it  may  be  stated  that  the  auditor  who  has 
been  requested  to  design  stock  accounts  for  any  special  busi- 


METHODS  OF  ACCOUNT.  75 

ness  will  do  well  to  avail  himself  of  whatever  practical  ex- 
perience may  be  possessed  by  his  clients,  or  their  managers. 
Nevertheless,  he  should  take  the  earliest  opportunity  of  veri- 
fying the  experience  thus  utiHzed  by  his  own;  and,  where  he 
should  be  so  fortunate  as  to  possess  some  practical  knowledge 
of  the  particular  business  in  question — a  knowledge  he  is  very 
likely  to  have  had  the  opportunity  of  acquiring — he  will  doubt- 
less find  it  of  the  greatest  assistance. 

CAPITAL    STOCK    ACCOUNTS    OF    COMPANIES. 

With  regard  to  these  accounts,  much  that  might  have  been 
said  has  been  anticipated  under  the  heading  of  "  SELF- 
BALANCING  LEDGERS  "  (q.  v.).  Each  class  of  shares  or 
stock  should  have  an  account  opened  for  it  in  the  general 
ledger,  and  such  account  will,  in  fact,  become  the  controlling 
account  for  that  particular  stock  ledger.  By  this  means  all 
transfers  are  kept  out  of  the  general  ledger,  and — after  the 
issue  has  once  been  completed — no  further  entries  are  neces- 
sary. Should  the  issue  be  a  large  one,  however,  it  is  often 
preferable  to  open  separate  general  ledger  accounts  for  "  ap- 
plications," "  allotments,"  and  "  calls,"  respectively. 

This  system  may  be  greatly  assisted  by  the  addition  of  an 
extra  column  to  the  debit  side  of  the  general  cash  book,  the 
items  entered  in  such  column  being  posted  to  the  stock  ledger, 
and  the  totals  periodically  posted  to  the  general  ledger  in  the 
usual  way.  If  this  method  be  adopted,  the  duplication  of  en- 
tries is  reduced  to  a  minimum,  and  the  auditor's  work  becomes 
not  only  proportionately  lighter,  but  also  much  more  certain. 
With  large  companies,  whose  stockholders  are  very  numerous, 
it  is  usual  to  devote  a  special  cash  book  to  capital  receipts,  and 
carry  totals  only  to  the  general  cash  book.  This  system  lends 
itself  readily  to  the  method  advocated. 

For  full  information  upon  this  subject  the  reader  is  referred 
to  the  author's  "  Bookkeeping  for  Company  Secretaries,"  or 
"  Advanced  Accounting." 


76  AUDITING. 

SUSPENSE    ACCOUNTS. 

Most  of  the  points  comprised  under  this  heading  will  be 
found  to  be  fully  dealt  with  at  a  later  stage,  under  the  heads 
of  "  Outstanding  Assets  and  Liabilities "  and  "  Contingent 
Liabilities  " ;  but  the  following,  which  refer  rather  to  questions 
of  account  than  to  general  matters  of  principle,  may  be  more 
appropriately  considered  here. 

Any  outstanding  amounts  due,  or  supposed  to  be  due,  either 
to  or  by  an  undertaking,  should  never  be  allowed  to  stand  as 
balances  upon  a  nominal  account.  The  great  convenience  of 
bringing  the  balance  down  on  the  nominal  account,  as  opposed 
to  opening  a  Suspense  or  Reserve  Account  which  will  naturally 
have  to  be  closed  the  following  morning,  makes  this  method 
of  bookkeeping — if,  indeed,  it  can  be  called  a  method — a  great 
favorite  with  a  certain  class  of  bookkeepers;  but  the  objections 
that  can  be  raised  against  such  a  procedure  are  quite  suffi- 
cient to  outweigh  any  advantages  which  it  may  be  supposed 
to  possess.  From  a  bookkeeper's  point  of  view,  doubtless,  the 
balance  on  the  nominal  account  may  be  deemed  to  answer  all 
purposes  sufficiently  well,  but  the  auditor  must  take  a  higher 
view  of  matters.  In  the  first  place,  the  balance  is  very  apt  to 
be  lost  sight  of,  and  consequently  no  adjustment  made,  at  the 
close  of  the  next  period — particularly  where  a  standing  bal- 
ance of  petty  cash  in  hand  is  left  open  upon,  say,  the  office 
expenses  account.  Secondly,  the  method  is  open  to  abuse  on 
the  part  of  a  fraudulent  bookkeeper,  and — in  the  absence  of 
the  suggestive  headings  lof  suspense  accounts — ^the  matter 
might  possibly  escape  the  vigilance  of  the  auditor.  And, 
again,  it  is  a  distinct  advantage  to  arrange  the  trial  balance 
so  that  it  may  contain,  in  itself,  all  the  information  necessary 
for  closing  the  books,  and  preparing  the  balance  sheet  and 
trading  and  profit  and  loss  accounts,  and  this  can  only  be  con- 
veniently effected  by  making  the  necessary  adjusting  entries, 
by  means  of  suspense  accounts,  before  the  trial  balance  is 
extracted. 


METHODS  OF  ACCOUNT.  ^J 

THE  TREATMENT  OF  BAD  AND  DOUBTFUL 

DEBTS. 

An  intelligent  system  of  dealing  with  the  difficult  question 
of  bad  and  doubtful  debts  is  of  such  assistance  to  all  commer- 
cial houses  that  the  auditor  should  lose  no  opportunity  of  sug- 
gesting that  the  matter  be  put  upon  a  scientific  basis. 

A  very  good  method  is  the  following:— 

As  soon  as  a  debt  becomes  at  all  doubtful,  or  sufficiently 
overdue  to  merit  special  attention,  it  is  transferred  to  a  doubt- 
ful debts  ledger,  which  is  ruled  as  follows :  On  the  left-hand 
page  are  spaces  for  two  or  three  ordinary  ledger  accounts, 
while  the  right-hand  page  is  left  blank  for  such  memoranda 
as  "  When  applied  for,'*  "  When  sued,"  "  When  failed,"  and 
full  particulars  as  to  progress  of  subsequent  realization  of  the 
estate.  When  an  account  becomes  hopelessly  bad  (either  by 
reason  of  the  statute  of  limitations  intervening,  or  an  execu- 
tion remaining  unsatisfied,  or  a  final  dividend  having  been  dis- 
tributed, or  a  composition  accepted),  and  not  until  then,  the 
account  is  written  off  to  bad  debts  account;  but  on  no  account 
should  an  amount  be  written  off  until  it  is  known  to  be  irre- 
trievably bad,  as  an  amount,  once  written  off,  is  almost  certain 
never  to  be  recovered.  It  will  be  noted  that  not  the  least  of 
the  advantages  afforded  by  this  system  is  the  peculiar  promi- 
nence it  gives  to  all  overdue  accounts,  thus  offering  special 
facilities  for  their  receiving  the  particular  attention  they  so 
urgently  require.  In  a  large  concern,  moreover,  it  is  an  obvi- 
ous advantage  that  overdue  accounts  should  pass  into  the  con- 
trol of  a  different  ledger  clerk. 

Where  it  is  the  custom  to  pass  all  overdue  debts  on  to  an 
attorney  or  agency  for  collection,  their  simultaneous  transfer 
to  the  doubtful  debts  ledger  provides  a  convenient  record  of 
all  matters  in  their  hands. 

The  necessary  provision  for  loss  upon  bad  and  doubtful 
debts  may  be  made  by  means  of  the  reserve  for  bad  debts 
account,  which  may  be  credited  with  the  estimated  amount  of 


78  AUDITING. 

such  loss,  while  the  bad  debts  (nominal)  account  is  debited 
in  the  usual  way.  The  memoranda  recorded  on  the  blank 
pages  of  the  doubtful  debts  ledger  will  readily  afford  all  avail- 
able information  upon  which  a  proper  valuation  of  the  amount 
necessary  to  be  written  off  may  be  prepared,  and  the  systematic 
focussing  of  such  information  upn  the  method  here  described 
will  generally  admit  of  a  much  more  reliable  estimate  being 
prepared  than  would  otherwise  have  ben  practicable. 

A  practice  which  has  been  found  desirable  in  some  lines  of 
business  is  to  charge  to  profit  and  loss  each  year  (and  credit 
to  reserve  for  bad  debts)  an  amount  for  estimated  loss  on  bad 
debts  equal  to  a  certain  percentage  of  the  sales.  The  argu- 
ment in  this  case  is  that  the  loss  was  not  really  made  in  the 
year  when  it  was  discovered,  but  in  the  year  when  the  sale 
was  effected.  An  analogous  practice  is  to  set  up  a  reserve 
equivalent  to  a  certain  percentage  on  the  uncollected  accounts. 

It  is  obvious  that  the  loss  eventually  to  be  realized  on  ac- 
counts uncollected  at  .the  date  of  the  balance  sheet  cannot  be 
accurately  determined  or  estimated  merely  by  allowing  for  a 
certain  amount  of  loss  on  overdue  accounts  and  assuming 
that  all  accounts  not  yet  due  are  good;  all  bad  accounts  were 
at  one  period  of  their  existence  in  the  latter  class.  The  aim  in 
stating  the  results  of  a  year's  business  should  be  to  deduct 
from  the  apparent  profits  on  the  sales  any  losses,  the  prob- 
ability of  which  may  be  foreseen  by  reference  to  past  experi- 
ence; hence  it  follows  that  a  reserve  should  be  made  for  the 
entire  amount  of  probable  loss  on  uncollected  accounts,  one 
of  the  principal  factors  being  the  percentage  either  to  sales  or 
outstandings  experienced  in  the  past. 

Since  the  loss  which  may  eventually  be  sustained  on  doubt- 
ful debts  is  to  a  considerable  extent  a  matter  of  opinion — 
though  not  wholly  so — the  auditor  cannot  dictate  the  amount 
of  the  reserve  which  should  be  set  up.  If  not  fully  satisfied, 
however,  as  to  the  adequacy  thereof,  he  should  call  specific 
attention  to  the  fact  in  his  report. 


METHODS  OF  ACCOUNT.  79 

THE    USE    OF    THE   JOURNAL. 

There  was  a  time  when  practically  every  entry  in  a  set  of 
books  went  through  the  journal,  either  having  its  inception 
in  that  book  or  being  included  in  the  totals  of  other  books 
which  were  periodically  journalized.  Modern  practice,  how- 
ever, has  demonstrated  that  separate  books  for  various  classes 
of  entries,  such  as  purchases,  sales,  &c.,  are  desirable  for  a 
number  of  reasons,  and  that  there  is  no  good  reason  why  the 
entries  in  these  books  should  be  rehashed  in  the  journal,  either 
in  detail  or  total,  but  rather  that  postings  should  be  made  di- 
rectly from  the  books  of  original  entry  to  the  ledgers.  Con- 
sequently the  journal,  as  quite  generally  used  among  progres- 
sive business  houses,  is  now  restricted  to  such  entries  as  can- 
not be  made  in  the  books  specially  designed  to  receive  certain 
classes  of  entries. 

The  journal  is  useful  for  recording  inventory  totals,  closing 
entries,  &c.,  entries  being  made  therein  in  preference  to  mak- 
ing transfers  between  accounts  in  the  ledgers.  The  latter 
method  is  taught  in  many  bookkeeping  schools,  but  it  is  not 
to  be  commended. 

WAGES    AND    SALARIES. 

The  best  method  of  paying  wages  has  already  been  detailed 
in  Chapter  I.,  and  therefore  nothing  further  need  be  said  upon 
that  subject  here. 

SALARIES  should,  in  large  concerns,  be  dealt  with  in  a 
manner  as  near  thereto  as  practicable.  The  distinction  made 
by  writers  between  wages  and  salaries  is  by  no  means  invari- 
ably clear,  and  therefore  some  definition  seems  desirable.  By 
Wages  is  meant  the  cost  of  labor,  and  also  the  cost  of  the 
immediate  supervision  of  such  labor  (foremen,  &c.),  which 
would  probably  be  paid  for  at  the  same  time  and  in  the  same 
manner — in  a  word,  cost  of  artisans'  or  laborers'  work.  By 
Salaries  is  meant  the  weekly  or  other  payments  to  managers, 
salesmen,  clerks,  and  other  more  educated  workers.       Thus, 


80  AUDITING. 

wages  will  be  always  an  expense  of  production;  but  salaries 
may  be  an  expense  of  production,  distribution,  or  administra- 
tion, although  generally  one  of  the  two  latter.  The  above 
definitions  are  by  no  means  universally  accepted,  but  for  pres- 
ent purposes  the  classification  according  to  method  of  payment 
and  of  audit  appears  to  be  the  most  convenient. 

The  best  method  of  recording  the  payment  of  salaries  is 
by  means  of  a  Salary  Book,  ruled  horizontally  for  the  names 
of  employees  and  vertically  with  columns  for  the  successive 
pay  periods.  The  total  of  each  column  represents  the  aggre- 
gate amount  paid  out  on  a  given  date,  and  is  the  amount  for 
which  credit  is  taken  in  the  cash  book.  Where  salaries  are 
not  paid  by  individual  checks,  a  check  should  be  drawn  for 
the  total  in  preference  to  paying  from  petty  cash.  This  form 
of  salary  book  obviates  the  necessity  for  a  separate  salary 
ledger  as  all  the  data  concerning  date  of  employment,  rate, 
increases  in  salary,  &c.,  can  be  shown  together  with  the 
amounts  actually  paid  from  week  to  week  or  month  to  month. 

Where  the  salary  book  is  not  written  up  by  some  one  who 
has  authority  to  approve  the  rates,  provision  should  be  made 
for  securing  approval  from  the  proper  person.  This  will 
usually  make  it  unnecessary  to  take  receipts. 

AGENTS'    ACCOUNTS. 

With  books  which  are  not  kept  by  very  skilled  bookkeepers, 
the  auditor  frequently  has  a  considerable  amount  of  addi- 
tional, and  wholly  unnecessary,  trouble  in  connection  with  the 
accounts  between  his  clients  and  their  agents,  or  between  his 
clients  (the  agents)  and  their  principals.  It  is  therefore  very 
desirable  that  agency  accounts  should  be  kept  upon  some 
definite  and  practicable  system.  The  conditions  of  agency  are 
so  various  that  it  is  impossible  to  deal  in  detail  here  with  every 
conceivable  set  of  circumstances  arising  in  connection  with 
this  subject,  but  it  may  be  pointed  out,  in  general  terms,»that 
where  the  remuneration  of  the  agent  is  dependent  upon  the 


METHODS  OF  ACCOUNT.  8 1 

amount  of  sales  or  purchases  effected  by  him,  every  considera- 
tion of  convenience  is  in  favor  of  a  special  sales  or  purchase 
book  being  employed  for  his  transactions ;  or,  at  all  events,  a 
special  column  being  devoted  to  these  transactions  in  the  gen- 
eral sales  or  purchase  book,  as  the  case  may^be.  When,  on 
the  other  hand,  the  remuneration  of  the  agent  is  by  way  of 
profits,  or  a  percentage  on  the  profits  earned,  whether  gross 
or  net,  the  accounts  should  be  so  schemed  that  an  "  Agency 
Account "  is  opened  in  the  general  or  private  ledger,  which 
virtually  becomes  the  trading,  or  profit  and  loss  account  in 
respect  of  the  transactions  with  which  the  agent  is  concerned. 
From  many  points  of  view  there  is  much  in  common  between 
agency  accounts  and  consignment  accounts,  and  therefore  the 
considerations  obtaining  under  the  latter  heading  will  frequent- 
ly be  found  of  use  in  connection  with  the  accounts  between 
agents  and  principals,  and  may  be  usefully  consulted  before 
formulating  any  definite  scheme  upon  which  these  latter  ac- 
counts should  be  kept. 

CONSIGNMENT    ACCOUNTS. 

It  has  already  been  pointed  out  under  the  previous  heading 
that  the  most  convenient  method  of  dealing  with  many  agency 
accounts  is  to  so  arrange  the  books  that  what  is  virtually  a 
special  trading,  or  a  special  profit  and  loss,  account  should 
be  kept  in  respect  of  these  particular  items.  These  remarks 
apply  a  fortiori  to  consignment  accounts.  The  statement  will 
be  found  in  many  text  books  on  bookkeeping  (chiefly,  how- 
ever, of  the  unpractical  order)  that  when  a  consignee  receives 
goods  from  a  consignor  it  is  unnecessary  that  any  entry  should 
be  made  in  his  books  in  respect  thereof.  This,  it  will  be 
obvious,  is  a  complete  departure  from  the  fundamental  rule  of 
bookkeeping,  which  requires  that  it  should  be  "a  record  of 
transactions,"  and  this  proposition  seems  so  self-evident  that 
no  time  will  be  wasted  in  more  fully  discussing  it.  Apart,  how- 
ever, from  this  academical  objection,  it  may  be  pointed  out 
that  every  consideration  of  convenience  requires  that  in  the 


82  AUDITING. 

books  of  the  consignee  there  should  be  two  accounts  for  the 
purpose  of  recording  his  transactions  with  the  consignor;  the 
one  virtually  a  trading  account,  showing  the  actual  result  of  the 
trading  in  the  goods  consigned,  and  the  other  a  personal  ac- 
count, showing  the  position  between  the  consignee  and  the 
consignor. 

In  some  cases  where  several  consignments  are  received  from 
the  same  consignor,  it  may  be  found  desirable  to  open  a  sepa- 
rate trading  account  for  each,  but  one  personal  account  will 
usually  suffice. 

The  same  remarks  apply  to  the  books  of  the  consignor  him- 
self, except  that — as  he  is  dependent  entirely  upon  the  con- 
signee for  the  record  of  transactions  after  the  goods  have  once 
left  his  office — it  becomes  possible  in  some  cases  to  adequately 
record  these  transactions  in  one  account.  In  the  vast  majority 
of  cases,  however,  it  will  be  found  that  two  accounts  are  not 
only  more  convenient,  but  in  the  long  run  involve  less  trouble 
and  time  in  the  keeping. 

A  fuller  and  more  detailed  exposition  of  the  best  method 
of  dealing  with  these  accounts  will  be  found  in  the  author's 
"  Bookkeeping  for  Accountant  Students,"  to  which  the  reader 
is  referred. 

THE    ACCOUNTS    OF   BRANCH    ESTABLISHMENTS 

This  is  a  point  upon  which  the  auditor  will  frequently  ex- 
perience considerable  difficulty,  by  reason  of  the  defective  sys- 
tem of  record  employed,  and  it  is  therefore  of  especial  import- 
ance in  connection  with  the  subject  of  auditing  that  a  really 
practical  system  of  bookkeeping  should  be  dealt  with  in  this> 
connection. 

It  may  be  stated  at  the  outset  that  the  accounts  of  branch 
establishments  may  be  ranged  under  two  wholly  different  cate- 
gories. In  the  first  case  the  accounts  of  the  branch  are  kept 
at  the  branch  itself,  and  are  practically  independent  of  those 
kept  at  the  head  office ;  in  the  second  case  a  minimum  possible 


OF   THE 

UNIVERSITY 

OF 

METHODS  OF  ACCOUNT.  83 

amount  of  accountancy  is  employed  at  the  branch,  returns 
being  made  to  the  head  office,  and  the  transactions  of  the 
branch  incorporated  in  the  head  office  books.  The  latter  class 
of  accounts,  of  course,  present  no  serious  difficulty,  and,  indeed, 
for  all  practical  purposes  the  bookkeeping  is  the  same  as  though 
the  branch  establishment  did  not  exist,  except  that  for  statisti- 
cal purposes  it  may  be  thought  desirable  that  some  of  the 
nominal  accounts  should  be  divided  up  so  as  to  show  the  trans- 
actions of  the  branch  separately  for  purposes  of  comparison. 

It  is  however,  with  regard  to  the  former  class  that  most 
difficulties  are  likely  to  arise.  In  this  connection  it  may  be 
pointed  out  that  any  difficulty  or  complication  which  can  be 
conceived  may  be  at  once  got  over  if  the  system  of  accounts 
at  the  branch  office  be  regarded  in  precisely  the  same  light  as 
though  the  ledgers  recording  these  transactions  were  in  point 
of  fact  kept  at  the  head  office  in  self -balancing  ledgers,  in 
respect  of  which  controlling  accounts  were  to  be  found  in  the 
head  office  ledgers  themselves.  These  controlling  accounts  in 
the  head  office  ledgers,  which,  of  course,  will  be  written  up 
from  returns  made  by  the  branches,  will  provide  the  means  of 
controlling  the  record  of  transactions  in  the  branch  ledgers, 
and  at  the  same  time  combine  the  whole  system  of  accounts 
into  one  entity.  On  the  other  hand,  there  should  be  comple- 
mentary accounts  in  the  branch  office  books,  so  that  these  them- 
selves may  be  made  self -balancing. 

When  balancing  time  comes  it  is  necessary  that  a  trial  bal- 
ance should  be  taken  of  the  branch  books,  and  sent  to  the 
head  office,  and  this  will  be  found  to  explain  and  verify  the 
controlling  account  in  the  head  office  books  dealing  with  the 
branch  transactions.  The  trial  balance  at  the  head  office  can 
then  be  amplified  so  as  to  give  effect  to  these  records. 

In  many  cases  it  will  be  found  preferable  not  to  employ  any 
banking  account  at  the  branch  at  all,  but  to  receive  and  pay 
all  accounts  through  the  head  office  alone;  and,  where  the 
nature  of  the  business  renders  this  possible,  every  consideration 
of  expediency  will  be  in  favor  of  its  being  carried  out. 


84  AUDITING. 

Another  point  which  is  well  worth  bearing  in  mind,  where 
it  can  be  practically  applied,  is  that  with  certain  classes  of 
business — that  is  to  say,  those  which  deal  with  the  sale  of 
goods  in  bulk  without  the  bulk  being  broken,  it  is  of  inestimable 
advantage  for  the  purchases  to  be  all  made  at  the  head  office, 
and  the  goods  supplied  to  the  branch  offices  being  supplied 
to  them  by  the  head  office  at  selling  price.  The  stock  ac- 
count at  the  branch  office  then  becomes  much  simplified,  and 
the  balance  of  such  stock  accounts  should  represent  the  stock 
actually  available  on  hand,  and  without  any  adjustments  being 
necessary  in  respect  of  estimated  or  actual  gross  profit.  It 
is  not  necessary  that  this  system  should  at  all  confuse  the 
question  of  the  profits  actually  earned  by  the  branch,  because 
there  is  not  the  least  difficulty  in  the  goods  supplied  to  the 
branch  being  credited  to  a  special  account  in  the  head  office 
books,  instead  of  being  credited  to  the  general  sales  account. 

The  mere  fact  that  a  business  has  numerous  branches,  in- 
stead of  merely  one,  in  no  way  alters  the  fundamental  princi- 
ples on  which  the  accounts  of  these  branches  should  be  kept; 
but  it  need  hardly  be  added  that  it  strengthens  the  argument  in 
favor  of  these  branch  accounts  being  organized  and  rigidly 
kept  upon  a  thoroughly  sound  basis  of  internal  check,  and  one 
which  renders  itself  readily  available  to  the  scrutiny  and  super- 
vision of  the  auditor. 

The  introduction  of  mechanical  bookkeeping  devices  has 
materially  affected  the  accounting  methods  of  branch  offices. 
It  is  now  possible  to  duplicate  practically  all  branch  records  in 
convenient  form  for  transmittal  to  the  head  office,  there  to 
be  filed  in  binders  provided  for  the  purpose,  and  thus  furnish- 
ing the  means  whereby  instant  reference  can  be  had  to  branch 
transactions.  The  audit  thereof  can  usually  be  conducted 
at  the  head  office  with  most  satisfactory  results. 

Through  the  use  of  typewriters  adapted  for  the  purpose, 
and  by  one  operation,  customers'  ledgers  are  posted,  customers' 
monthly  statements  are  written  and  duplicate  ledger  sheets 


METHODS  OF  ACCOUNT.  85 

are  prepared  for  the  head  office,  in  addition  to  which  the 
machine  automatically  registers  and  adds  the  amounts  posted, 
which  admits  of  a  daily  arithmetical  proof  of  all  postings. 


CAPITAL    AND    REVENUE. 

The  distinction  between  capital  expenditure  and  revenue 
expenditure  is  one  of  primary  importance,  as  bearing  upon 
the  fundamental  question  of  what  profits  have  actually  been 
made  by  an  undertaking  during  any  given  period.  But  it  is 
thought  that  much  unnecessary  complication  has  been  intro- 
duced in  discussing  this  subject,  and  that,  when  these  wholly 
irrelevant  matters  are  brushed  aside,  the  fundamental  question 
will  be  found  to  be  simplicity  itself. 

Briefly  stated,  the  question  can  in  any  event  be  answered 
by  finding  the  answer  to  the  following  question :  "  Has  the 
particular  expenditure  incurred  in  any  individual  case  been 
incurred  for  the  sake  of  improving  the  earning  capacity  of  the 
undertaking?"  If  the  answer  to  this  question  is  in  the 
affirmative  then,  and  to  that  extent,  the  expenditure  in  ques- 
tion is  capital  expenditure.  But  if  it  has  only  had  the  eflFect 
of  putting  the  earning  capacity  of  the  undertaking  upon  the 
same  footing  as  that  which  had  previously  otbained  (and 
which  has  since  declined  by  the  ordinary  process  of  wear  and 
tear,  or  the  effluxion  of  time,  in  respect  of  which  no  provision 
has  been  made),  it  must  be  charged  against  revenue.  The  pre- 
cise meaning  of  this  latter  qualification  is  that  the  mere  renezval 
of  wasting  assets,  not  otherwise  provided  for,  cannot  be  called 
capital  expenditure,  but  that  any  extension,  or  the  acquiring 
of  fresh  assets,  is  in  the  nature  of  capital  expenditure. 

PARTNERSHIP    AGREEMENTS. 

There  is  an  increasing  tendency  upon  the  part  of  commercial 
men  entering  into  partnership  to  consult  professional  account- 
ants as  to  the  provisions  which  should  be  made  in  the  partner- 
ship agreement  with  regard  to  the  accounts.     This  tendency 


86  AUDITING. 

is  distinctly  one  to  be  encouraged,  as  having  in  the  long  run 
the  effect  of  not  only  consulting  the  immediate  interests  of 
the  partners  with  regard  to  the  keeping  of  proper  accounts,  and 
the  equitable  apportionment  of  profits,  but  also  as  tending  dis- 
tinctly to  lessen  the  probability  of  disputes  in  the  future  arising 
out  of  questions  of  account. 

The  subject  is,  therefore,  one  which  may  be  very  profitably 
undertaken  by  professional  accountants,  and  that  without  in 
the  least  usurping  the  functions  of  lawyers.  This  being  so, 
it  has  been  thought  desirable  to  append  a  few  notes  as  to  the 
points  most  ordinarily  arising  in  partnership  agreements,  to- 
gether with  suggestions  as  to  how  they  should  be  dealt  with. 

These  are  as  follows : — 

(i)  The  respective  shares  of  partners  in  profits  and  losses 
should  be  clearly  stated;  and  where  it  is  provided  that  these 
shall  be  varied  during  the  continuance  of  the  partnership,  it  is 
especially  important  that  anything  which  might  tend  to  effect 
the  amount  of  agreed  profits  as  between  the  partners  should 
be  very  clearly  defined. 

(2)  It  should  be  borne  in  mind  that,  in  the  absence  of  ex- 
press provision  to  that  effect,  partners  are  not  entitled  to 
interest  upon  capital.  If,  therefore,  they  are  to  receive  inter- 
est, the  fact  should  be  clearly  stated. 

(3)  The  rate  of  interest  on  loans  by  partners  to  the  firm 
should  be  expressly  stated. 

(4)  Not  only  should  the  amount  of  capital  to  be  introduced 
by  each  partner  at  the  outset  be  expressly  defined,  but  pro- 
vision should  be  made  as  to  the  manner  in  which  undrawn 
profits  are  to  be  dealt  with.  That  is  to  say,  whether  they  are 
to  be  treated  as  capital  or  as  loans,  the  distinction  being  espe- 
cially important  where  it  is  provided  that  capital  does  not  bear 
interest  but  that  loans  do. 


METHODS  OF  ACCOUNT.  87 

(5)  The  amount  to  be  drawn  by  each  partner  from  time  to 
time  on  account  of  profits  should  be  clearly  stated,  together 
with  the  penalty  in  the  event  of  such  limit  being  exceeded. 

(6)  If  it  desired  that  interest  should  be  debited  to  partners 
in  respect  of  drawings,  the  fact  should  be  clearly  stated. 

(7)  The  circumstances  under  which  a  partnership  may  be 
dissolved  should  be  clearly  provided.  Too  much  attention 
cannot  be  given  to  this  point. 

(8)  The  exact  position  of  each  partner,  in  the  event  of  a 
dissolution,  is  also  a  matter  of  the  very  greatest  importance. 

(9)  In  the  event  of  a  partner  retiring  or  dying,  the  agree- 
ment should  distinctly  provide  the  amount  payable  to  him  (or 
to  his  representative,  as  the  case  may  be),  and  the  method  by 
which  it  is  to  be  ascertained,  also  the  time  in  which  it  must  be 
paid,  and  the  interest  (if  any)  it  is  to  bear  in  the  meantime. 
It  is  important  that  the  business  should  not  be  crippled  by 
making  this  period  unduly  short. 

(10)  In  connection  with  the  preceding  it  is  frequently  con- 
venient that  some  special  arrangement  should  be  made  to 
obviate  the  necessity  of  the  books  being  balanced  and  stock 
taken  at  an  irregular  period. 

(11)  The  exact  scope  of  the  firm's  business  should  be  clearly 
defined,  with  a  view  to  avoiding  disputes  as  to  whether  certain 
profits  earned  by  the  individual  partners  come  under  the  part- 
nership agreement  or  not. 

(12)  The  extent  (if  any)  to  which  partners  are  entitled  to 
engage  in  other  operations,  outside  the  partnership  business, 
should  be  defined. 

(13)  It  should  not  only  be  provided  that  "proper  accounts 
are  to  be  kept,"  but  that  these  should  be  kept  upon  some  ade- 
quate system  of  double  entry.  They  should  be  balanced  at 
stated  intervals,  and  audited  by  a  professional  accountant,  and 
provision  made  that  after  the  audited  accounts  have  been 


88  AUDITING. 

signed  by  the  partners  they  are  binding  upon  each  individual 
partner,  except  where  some  manifest  error  has  been  discovered 
within  a  reasonable  time — say,  three  months. 

(14)  In  addition  to  the  usual  arbitration  clause,  it  is  very 
expedient  that  there  should  be  one  to  the  effect  that  all  dis- 
putes upon  questions  of  account  should  be  referred  to  the  arbi- 
tration of  a  Certified  Public  Accountant  (preferably,  if  the 
question  of  expense  is  to  be  considered,  the  regular  auditor  of 
the  firm),  and  it  should  be  further  provided  that,  in  the  event 
of  disputes  upon  questions  of  mixed  law  and  accounts,  such 
disputes  should  be  referred  to  the  arbitration  of  an  accountant 
and  a  lawyer,  the  arbitrators  having  power  to  appoint  a  referee 
before  commencing  their  reference. 


INSTRUCTIONS    AS    TO    PREPARATION    FOR 
AUDIT. 

As  a  fitting  conclusion  to  the  present  chapter,  a  brief  list  of 
instructions — such  as  might  be  prepared  by  the  auditor  for 
the  guidance  of  the  bookkeeper,  showing  the  work  that  should 
be  done  before  the  audit  commences — is  appended.  Such  a  list 
is  the  following : — 

(i)  All  postings  should  be  completed,  all  additions  inked 
in,  all  balances  extracted,  and  the  trial  balance  agreed. 

(2)  Vouchers  for  all  payments  should  be  arranged  in  order, 
and  made  available  for  the  auditor's  inspection. 

(3)  A  complete  list  of  all  books,  with  the  names  of  the  clerks 
in  charge  of  each,  should  be  prepared. 

(4)  If  possible,  the  cash  in  hand  at  the  date  of  closing  the 
books  should  be  paid  into  the  bank;  but,  where  this  has  not 
been  done,  the  cashier  must  have  his  books  written  up  to  date, 
and  the  vouchers  ready. 

(5)  A  complete  inventory  of  the  stock — priced,  extended, 
footed,  and  duly  certified — should  be  ready. 


METHODS  OF  ACCOUNT.  89 

(6)  All  bonds,  notes,  deeds,  and  other  securities  should  be 
ready  for  production  when  called  for  by  the  auditor,  and  a 
list  thereof  should  be  prepared. 

(7)  A  list  of  all  overdue  accounts  showing  the  provision 
(if  any)  which  it  is  deemed  necessary  to  make  against  possible 
loss  should  be  prepared. 

(8)  A  memorandum  should  be  kept  of  any  other  matter  to 
which  it  is  thought  desirable  to  call  the  auditor's  attention. 

(9)  A  draft  balance  sheet  and  profit  and  loss  account  should 
be  prepared. 

As  has  already  been  pointed  out,  some  of  the  duties  com- 
prised in  the  foregoing  may  devolve  upon  the  auditor  in  the 
case  of  a  private  firm  or  trader ;  but  in  the  case  of  a  corporation 
audit  it  is  particularly  desirable  that  these  matters  should  be 
completed  before  the  auditor  commences  his  investigation,  as 
it  cannot  be  too  strongly  impressed  upon  all  concerned  that  the 
accounts  submitted  to  the  stockholders  are  not  the  auditor's  ac- 
counts, but  the  accounts  of  the  directors. 


CHAPTER  III. 


SPECIAL    CONSIDERATIONS 
IN    DIFFERENT    CLASSES    OF    AUDITS. 


In  the  previous  chapters  the  rules  laid  down  have  been  of  as 
general  a  character  as  possible;  but  it  must  not  therefore,  be 
supposed  that  the  audit  of  every  concern  is  to  be  carried  out 
on  precisely  the  same  lines.  The  opportunities  for  fraud  will 
vary  widely  in  concerns  of  a  different  character,  while  the 
chances  of  unintentional  errors  of  principle  and  in  detail  will 
likewise  vary  extensively  in  different  classes  of  concerns. 

As  has  been  already  intimated,  the  auditor  who  wishes  to 
be  of  the  greatest  possible  service  to  his  cHent  should  avail 
himself  of  every  opportunity  to  become  practically  acquainted 
with  the  working  of  the  business,  as  it  will  only  be  when  he 
has  some  real  acquaintance  with  the  matter  he  is  discussing 
that  his  opinion  upon  the  accounts  of  any  given  business  will 
possess  any  great  weight;  for  if  he  has  no  knowledge  of  the 
business  carried  on  it  is  impossible  for  him  to  intelligently 
criticise  the  system  of  accounts  that  records  the  transactions 
effected,  and  if  he  has  no  knowledge  of  the  nature  of  such 
transactions  it  is  hardly  to  be  expected  that  he  would  be  in  a 
position  to  form  any  reliable  opinion  as  to  the  risk  that  exists 
of  the  transactions  not  being  correctly  recorded  in  the  accounts. 
These  remarks  will,  perhaps,  appear  trite  to  many,  but  so  much 
has  been  said  about  accountants  "  confining  themselves  to  their 
own  province  "  that  it  has  become  necessary  to  point  out  the 
utter  inefficiency  of  any  audit  which  confines  its  investigations 
to  an  inquiry  as  to  the  technical  correctness  of  the  bookkeeping. 

90 


WHOLESALE  MERCHANTS.  9I 

The  object  of  the  following  chapters  is  not  to  supply  the 
reader  with  such  special  knowledge  concerning  each  class  of 
undertaking  as  it  may  be  desirable  for  him  to  possess  before 
presuming  to  certify  as  to  the  correctness  of  its  accounts — 
such  a  knowledge  cannot  be  altogether  imparted  by  any  book, 
and  is  beyond  the  scope  (as  it  is  beyond  the  compass)  of  the 
present  volume — but  in  the  following  paragraphs  the  reader 
will  find  his  attention  directed  to  those  points  most  worthy 
of  his  consideration  in  each  of  the  leading  classes  of  accounts 
he  is  likely  to  be  called  upon  to  verify.  The  special  opportuni- 
ties of  fraud,  and  the  points  upon  which  an  innocent  misstate- 
ment of  facts  is  most  likely  to  occur  will,  so  far  as  possible, 
claim  attention ;  while  it  may  be  added  that  "The  Accountants' 
Library"  provides  a  series  of  handbooks  dealing  with  the  ac- 
counts of  most  of  the  leading  industries,  and  is  likely  to  prove 
useful  to  the  reader — whether  practitioner  or  student. 

With  these  preliminary  remarks,  the  categorical  considera- 
tion of  the  subject  will  be  proceeded  with. 

I.     COMMERCIAL    ACCOUNTS. 

(a)  WHOLESALE  MERCHANTS.— The  chief  openings 
for  fraud  in  these  accounts  are :  Theft  of  stock ;  misstatement 
of  cash  sales;  fraudulent  payment  of  bogus  purchases;  mis- 
appropriation of  moneys  received  in  payment  of  accounts — 
such  accounts  being  either  left  open  or  written  off  as  "  bad  " ; 
petty  theft  by  the  raising  of  fictitious  items  of  discount  allowed 
on  receipts,  or  interest  incurred  on  payments ;  and  similar  mat- 
ters. Of  what  may  be  styled  "  innocent "  errors,  the  most 
common  are  errors  of  principle  in  the  valuation  of  stock-in- 
trade;  insufficient  depreciation  on  leases  and  furniture;  omis- 
sion to  allow  for  outstanding  discounts  and  interest ;  errors  of 
principle  in  the  valuation  of  foreign  currencies;  omission  of 
liability  on  outstanding  expenses,  and  on  bills  discounted;  in- 
sufficient provision  for  bad  debts,  &c.  There  are  not  many 
trade  details  with  which  the  auditor  will  require  to  be 
acquainted  in  these  accounts,  but  he  will  do  well  to  ascertain 


92  AUDITING. 

the  terms  of  payment  and  discount  accorded  to,  and  by,  his 
clients,  and  to  make  use  of  this  knowledge  continuously.  Where 
the  terms  vary — and  they  generally  do  vary — they  should 
be  written  in  red  ink  at  the  head  of  each  account  in  the  ledger. 
The  auditor  should  make  himself  acquainted  with  the  percent- 
age of  profit  expected  by  his  clients,  and  should  compare  it, 
both  with  the  actual  results  and  the  rate  generally  realized  by 
others  in  the  same  trade.  Stock  accounts  can,  almost  invari- 
ably, be  kept  by  merchants  and  warehousemen ;  but  this  is,  in 
practice,  only  occasionally  done. 

The  question  of  patents  or  trade-marks  sometimes  arises 
in  these  accounts,  but  the  consideration  thereof  is  more  appro- 
priately dealt  with  in  a  later  chapter. 

(b)  MANUFACTURING  TRADERS.— Under  this  head- 
ing are  intended  to  be  included  those  manufacturers  who  ordi- 
narily keep  a  stock  of  ready-made  articles,  and  who  do  not 
manufacture  exclusively  (or  principally)  "  to  order."  The 
preceding  paragraph  (a)  will  also  apply  to  the  consideration 
of  their  accounts;  but  a  few  additional  precautions  are  re- 
quired in  connection  with  their  manufacturing  departments. 

The  item  of  wages,  in  particular,  is  one  requiring  the  utmost 
care ;  and  the  question  of  depreciation  of  plant  and  machinery 
will  also  require  a  full  share  of  attention.  A  proper  system 
of  cost  accounting  becomes  all  but  essential.  It  is  probable 
that  the  auditor  will  find  some  such  system  in  operation ;  but  it 
is  at  least  equally  probable  that  the  actual  system  employed 
will  be  found  both  unscientific  and  unreliable. 

(c)  RETAILERS. — Retailers  who  give  credit  in  many  re- 
spects follow  upon  the  same  lines  as  the  wholesale  houses  in  the 
same  trade ;  but  the  increased  number  of  transactions  renders  a 
detailed  audit  more  difficult.  It  is  generally  quite  impossible  to 
call  back  all  the  postings  of  the  sales  ledgers,  but  the  balancing 
thereof  can  be  checked  without  difficulty,  and  must  always  be 
done.  The  list  of  balances  should  be  compared  with  the  ledger, 
and  the  footings  verified.     Where  the  business  is  very  volu- 


RETAILERS.  93 

minous,  the  audit  of  the  sales  ledgers  is  frequently  deputed  to 
some  of  the  counting-house  staff ;  but,  in  any  case,  the  auditor 
should  not  lose  his  grip  of  this  department,  and  should  occa- 
sionally check  the  balances  himself.  To  check,  say,  one  or 
two  ledgers  at  random  each  year  will  have  kll  the  moral  effecty 
of  checking  the  whole  set. 

Many  retail  houses  supply  goods  to  their  own  employees,  &c., 
at  reduced  rates,  and  allow  credit  until  the  following  pay-day. 
A  separate  "  Employees'  Ledger "  should  always  be  kept  in 
these  cases,  and  the  auditor  is  usually  expected  to  see  that  the 
payment  of  these  accounts  is  not  unduly  delayed.  At  every 
stock-taking  he  should  be  careful  to  ascertain  that  no  amount 
stands  to  the  debit  of  an  employee  who  has  left. 

The  purchase  ledger  is  generally  of  comparatively  manage- 
able proportions;  consequently  it  is  rarely  impossible,  though 
not  as  a  rule  necessary  to  check  it  in  toto.  In  a  continuous 
audit  it  is  frequently  arranged  that  the  auditor  shall  pass  all 
the  purchase  ledger  statemejits  for  payment,  and  the  system 
has  much  to  recommend  it.  In  addition  to  seeing  that  each 
item  on  the  statements  is  also  in  the  ledger,  the  auditor  should 
make  the  ledger  clerk  initial — and  so  guarantee  the  correctness 
of — every  statement  that  is  submitted  by  him.  The  auditor 
should  also  compare  the  discount  deducted  with  the  terms  of 
payment  stated  at  the  head  of  each  account  in  the  ledger.  It 
need  hardly  be  added  that  this  passing  of  the  purchase  ledger 
statements  for  payment  is  not  a  necessary  part  of  any  audit, 
and — where  performed — it  should  command  a  special  fee. 

The  vouching  of  cash  received — whether  for  cash  sales  or 
sales  ledger  accounts — ^may,  under  a  good  system  of  internal 
check,  safely  be  left  to  the  care  of  the  staff;  but  it  is  the 
auditor's  duty  to  see  that  the  receipts  are  duly  banked  and  to 
verify  the  bank  balance.  A  large  retailer's  audit  will,  almost 
invariably,  be  continuous;  and  it  is  desirable  that  the  bank 
balance,  and  also  that  of  the  petty  cash,  be  examined  at  least 
once  a  month. 


94  AUDITING. 

The  examination  of  petty  cash  has  already  occupied  atten- 
tion {vide  Chapter  I.),  and  it  therefore  only  remains  to  add 
that — in  addition  to  vouching  for  the  bona  iides  of  all  pay- 
ments— it  is  essential  that  some  responsible  person  be  made 
accountable  for  the  correctness  of  the  dissection  of  the  items. 

The  departmental  accounts  must  not  be  lost  sight  of,  as 
they  form  one  of  the  most  important  branches  of  the  auditor's 
duties.  An  account  showing  the  sales,  purchases,  and  esti- 
mated stock  should  be  submitted  to  the  principals  each  month, 
and  the  preparation  of  this  account  frequently  devolves  upon 
the  auditor.  At  the  stock-taking  the  reconciliation  of  the  esti- 
mated figures  with  the  actual  stock  on  hand  may  also  profit- 
ably occupy  the  auditor's  attention. 

The  postings  of  the  private  ledger  should  always  be  called 
back,  and  it  is  highly  desirable  that  such  private  ledger  should 
contain,  within  itself,  all  the  materials  for  a  trial  balance. 

Bills  receivable  will  but  rarely  be  found  in  connection  with 
a  retailer's  business;  but  bills  payable  are  almost  certain  to 
exist,  and  will  require  attention. 

The  vouching  of  payments  for  salaries  must  not  escape  at- 
tention, but  it  calls  for  no  especial  comment  here. 

In  cash  businesses  the  problem  is  somewhat  simplified  by 
the  considerable  reduction  effected  in  the  number  of  sales 
ledger  accounts.  Indeed,  these  accounts  are,  of  course,  natur- 
ally abolished  in  name;  but  in  some  cases  they  remain  in  es- 
sence as  deposit  accounts  kept  by  regular  customers  who  wish 
to  avoid  the  trouble  of  remitting  with  every  order.  It  is  an 
important  part  of  the  auditor's  duty  to  see  that  deposit  ac- 
counts are  never  overdrawn  without  proper  authority,  and 
that  the  interest  credited  (if  any)  is  at  the  rate  agreed  upon. 

The  system  adopted  for  checking  the  accuracy  of  the  cash 
receipts,  will,  as  before,  require  the  auditor's  careful  considera- 
tion; but,  in  the  absence  of  any  special  arrangement  to  the 
contrary,  it  is  not  necessary  for  him  to  carry  his  investiga- 
tion into  the  accuracy  of  such  receipts  beyond  seeing  that  the 


CONTRACTORS.  95 

system  in  use  is  properly  carried  out,  and  that  the  stated  re- 
turns are  duly  banked. 

It  is  very  usual  for  credit  notes  to  be  issued  against  goods 
returned  by  customers;  and,  as  these  credit  notes  may  be 
used  in  payment  of  subsequent  purchases  by  the  customers, 
or  the  money  therefor  obtained  upon  application  to  one  of  the 
cashiers,  the  question  has  to  be  dealt  with  by  the  auditor.  It 
is  generally  arranged  that,  at  the  end  of  the  day,  the  petty 
cashier  shall  redeem  all  credit  notes  in  the  hands  of  the  receiv- 
ing cashiers,  the  amounts  being  charged  up  through  petty 
cash.  The  issue  of  credit  notes  must,  therefore,  be  carefully 
guarded  against  abuse;  and  it  is  essential  that  the  system 
under  which  the  various  departments  are  debited  with  their 
respective  returns  be  properly  arranged.  The  credit  notes 
should  always  be  compared  with  the  stubs,  and  presented  to 
the  auditor  for  cancellation.  Failure  to  properly  cancel  credit 
notes  has  in  several  instances  been  responsible  for  fraud,  which 
has  been  effected  by  a  dishonest  employee  securing  possession 
of  and  recashing  them. 

(d)  CONTRACTORS.— Under  this  heading  the  accounts 
of  those  manufacturers  who  keep  little  or  no  ready-made  stock 
will  be  dealt  with.  This  class  includes  builders,  engineers, 
shipbuilders,  &c. 

In  these  accounts  the  cost  of — and  profit  or  loss  arising 
from — each  contract  will  require  to  be  separately  stated;  the 
contractor,  in  fact,  opening  a  special  trading  account  for 
every  contract.  Cost  accounts  thus  form  an  especial  feature 
of  the  contractor's  books,  and  an  inquiry  into  the  principles 
upon  which  they  are  based  is  thus  a  most  profitable  occupation 
for  the  auditor. 

The  systems  upon  which  stores  are  issued,  and  wag^s 
recorded  and  paid,  are  also  of  the  greatest  importance;  and 
time  spent  upon  such  an  inquiry  is  likely  to  be  of  considerably 
greater  advantage  to  the  client  than  any  detailed  examination 
of  the  books. 


96  AUDITING. 

It  is  also  important  to  call  for  the  monthly  statements  from 
the  sub-contractors,  who  will  frequently  be  found  to  have  large 
claims  for  "  extras  "  which  do  not  appear  to  their  credit  on 
the  contractor's  books.  Probably  the  contractor  has  billed  the 
owner  for  these  identical  items  and  passed  the  amount  to  the 
credit  of  the  contract.  Frequently  it  will  be  found  that  an 
agreement  has  been  made  with  the  sub-contractor  to  pay  him 
for  the  extras  only  in  the  event  of  the  contractor  being  suc- 
cessful in  collecting,  but  the  books  in  the  meantime  show  a 
credit  to  the  contract  which  must  not  be  carried  to  profit  and 
loss,  and  which,  therefore,  mUvSt  be  offset  by  a  reserve  suffi- 
ciently large  to  cover  all  such  items  and  also  for  such  further 
claims  as  the  sub-contractor  may  have,  which  may  not  yet 
have  been  passed  upon  or  which  have  not  been  allowed  for 
various  reasons. 

The  extent  of  the  auditor's  examination  into  detail  will  be 
a  matter  depending  largely  upon  the  nature  and  magnitude  of 
the  undertaking.  A  detailed  audit  would  not  usually  be  neces- 
sary, as  the  main  points  could  generally  be  accomplished  by 
an  examination  of  the  general  ledger ;  in  any  case  the  leading 
principles  will  be  the  really  important  matter. 

The  same  rules  which  have  already  guided  the  auditor  as 
to  the  extent  of  his  inquiry  into  details  will  serve  him  here; 
the  larger  the  undertaking,  the  more  its  opportunities  of  in- 
ternal check,  and  consequently  the  less  necessity  for  the  pro- 
fessional auditor  to  check  every  detail.  Many  large  under- 
takings keep  their  own  staff  auditor,  who  is  responsible  for 
the  technical  accuracy  of  the  trial  balance. 

The  valuation  of  contracts  in  hand  and  the  calculation  of 
depreciation  are  both  matters  of  the  greatest  importance,  but 
they  will  be  more  conveniently  dealt  with  at  a  later  stage. 
(See  under  those  headings  in  Chapter  VI.) 

(e)  BREWERIES.— The  audit  of  a  brewery  is  a  matter 
concerning  which  some  experience  upon  the  part  of  the  auditor 


BREWERIES.  97 

is  especially  desirable,  and  it  is  by  no  means  easy  to  indicate, 
in  a  few  words,  the  salient  features  of  the  task  before  him. 

Theft  of  stock  and  of  collections  are,  perhaps,  the  two  main 
risks  run  by  brewers.  The  former  is  best  guarded  against  by 
properly  designed  stock  accounts,  and  the  comparative  sta- 
tistics deducible  therefrom,  combined  with  a  certain  amount 
of  practical  laiowledge — which  latter  the  auditor  will  most 
likely  have  to  take  upon  trust  from  the  master  brewer.  The 
second  risk  arises  from  the  fact  that  accounts  are  frequently 
collected  by  the  drivers;  the  matter  therefore  requires  great 
care,  but  it  presents  no  exceptional  features.  The  discounts 
allowed  must  not  be  passed  without  inspection,  however,  as 
they  can  easily  be  juggled  with. 

In  connection  with  saloons  controlled  by  the  brewery,  the 
auditor  should  see  that  all  the  revenue  receivable  from  this — 
as  well  as  from  every  other — class  of  investment  is  brought 
into  the  accounts  subject  only  to  due  provision  for  bad  and 
doubtful  debts.  In  most  cases  loans  will  be  due  from  the  ten- 
ants of  these  houses,  and  in  connection  with  these  loans  pro- 
vision against  loss  is  a  matter  of  considerable  importance,  and 
one  requiring  the  most  careful  consideration.  It  should,  more- 
over, be  borne  in  mind  that  the  limit  of  possiKfe  loss  in  most 
cases  greatly  exceeds  the  amount  actually  advanced,  inasmuch 
as  the  brewery  will  sometimes  have  guaranteed  a  loan  ob- 
tained by  the  tenant,  which  forms  a  first  charge  upon  the 
property.  The  aggregate  amount  of  such  guarantees  should, 
it  is  thought,  be  stated  upon  the  balance  sheet  as  a  contingent 
liability. 

Another  point  of  considerable  importance  is  the  question 
of  depreciation.  In  the  case  of  a  brewery  plant,  the  actual 
wear  and  tear  is  probably  less  than  in  the  case  of  most  under- 
takings, because  the  plant  will  not  be  working  every  day,  and 
thus — ^^apart  from  the  fact  that  it  is  running  a  comparatively 
small  number  of  hours  per  week — ^the  intervals  of  rest  afford 
facilities  for  making  satisfactory  and  permanent  repairs  to  a 


98  AUDITING. 

far  greater  extent  than  is  practicable  with  most  other  under- 
takings. The  result  is  that  a  brewery  plant  can  in  practice  be 
kept  at  a  very  high  state  of  efficiency  by  careful  and  reason- 
able repairs  and  renewals.  On  the  other  hand,  some  items 
are  especially  liable  to  depreciation  by  becoming  obsolete,  and 
this  important  fact  should  not  be  lost  sight  of. 

(/)  HOTELS.— The  accounts  of  hotels,  whether  belong- 
ing to  companies  or  to  private  persons,  do  not  call  for  any 
extended  comment.  The  auditor  who  is  accustomed  to  hotel 
accounts  will  be  able,  by  a  careful  examination  of  the  items 
comprised  in  the  profit  and  loss  account,  to  form  a  fairly  re- 
liable opinion  as  to  whether  or  not  any  leakage  exists.  If 
there  appears  to  be  any  reason  to  suspect  that  things  are  not 
as  they  should  be,  it  might  be  found  desirable  to  thoroughly 
examine  in  detail  the  charges  for  a  portion,  at  least,  of  the 
period  under  consideration ;  but,  under  ordinary  circumstances, 
it  is  not  usual  to  carry  the  investigation  behind  the  guests' 
ledger,  except  for  the  purpose  of  verifying  the  wine  room 
stock  books.  Proper  stock  accounts  ought  always  to  be  kept 
of  wines,  liquors,  cigars,  &c.,  and  these  should  be  carefully 
inspected,  especially  if  the  profit  and  loss  account  does  not 
show  an  adequate  return  on  this  department.  Where  the  book- 
keeper is  also  the  cashier,  especial  care  must  be  exercised  to 
ascertain  that  all  receipts  are  properly  accounted  for;  and  it 
is  also  important  to  see  that  the  petty  cash  disbursed  upon  be- 
half of  guests  has  been  duly  charged  to  their  accounts  and 
collected.  The  entries  in  the  purchase,  general  or  private 
ledgers  should  always  be  thoroughly  checked;  and  especial 
care  should  be  given  to  the  vouching  of  all  payments,  includ- 
ing wages. 

The  question  of  depreciation — ^here,  as  elsewhere — is  also 
a  most  important  one,  and  must  be  carefully  considered.  Such 
items  as  bedding  and  linen,  plate,  cutlery,  china  and  glass, 
&c.,  are  frequently  re- valued  for  each  balance  sheet,  instead 
of  being  depreciated  regularly ;  but  perhaps  a  better  plan  is  to 
debit  profit  and  loss  account  and  credit  renewals  account  with 


CLUB   ACCOUNTS.  99 

a  fixed  (ample)  provision  for  renewals,  the  actual  expendi- 
ture being  debited  to  renewals  account,  and  any  credit  bal- 
ance treated  as  a  reserve.  The  advantage  of  this  course  is 
that  it  equalizes  profits,  so  that  a  period  of  five  years  could 
be  averaged;  but  it  is  well  for  the  auditor  to  satisfy  himself 
that  the  amount  written  off  against  revenue  is  ample  for  all 
ordinary  contingencies. 

RESTAURANTS  follow,  in  many  respects,  the  same  lines 
as  hotels.  The  accounts  are,  in  some  ways,  simpler;  but,  on 
the  other  hand,  they  are  generally  less  complete.  An  experi- 
enced auditor  may  prove  himself  of  considerable  value  to  the 
proprietor  of  a  restaurant,  but  he  cannot  pretend  to  protect 
him  against  fraud  on  the  part  of  his  employees;  neither  is  it 
always  possible  for  him  to  detect  any  fraud  that  may  have  been 
committed.  He  can,  however,  prepare — or  superintend  the 
preparation  of — accounts  that  will  show  exactly  how  the  net 
profit  has  been  earned,  and  these  accounts  will  suffice  the  ex- 
perienced client,  for  he  knows  just  about  what  result  ought 
to  have  ensued  from  a  given  turnover,  and  so  can  judge  for 
himself  as  to  the  satisfactoriness  of  the  existing  management. 

It  is  important,  too,  that  the  auditor  examine  thoroughly  the 
system  of  collecting  for  meals  served  and  make  certain  that 
it  is  the  most  efficient  which  is  practicable  under  the  circum- 
stances obtaining  in  each  case. 

(g)  CLUB  ACCOUNTS.— The  accounts  of  clubs  follow 
very  much  upon  the  lines  previously  indicated  with  regard  to 
hotels;  but  there  are  one  or  two  points  with  which  it  seems 
desirable  to  deal  in  a  little  further  detail.  In  the  business  of 
an  hotel  it  is  practically  impossible  for  the  proprietors  to  rely 
upon  their  customers  to  in  any  way  assist  them  in  checking 
their  employees,  but,  in  the  case  of  clubs,  where  the  members 
themselves  are  the  proprietors  of  the  undertaking,  the  ac- 
counts can  be,  to  a  certain  extent,  modified  with  advantage 
with  a  view  to  devising  a  system  by  which  the  members  them- 
selves may  assist  in  preventing  fraud  upon  the  part  of  em- 
ployees. 


100  AUDITING. 

Numerous  instances  have  been  disclosed  where  the  members* 
dues  have  been  misappropriated,  and  this  has  usually  happened 
where  the  payments  were  in  currency.  It  is  a  good  plan, 
therefore,  to  print  a  request  on  the  bills  to  members  to  pay 
same  by  cheque  to  the  order  of  the  club. 

It  is  also  advisable  to  request  the  members  to  pay  their 
house  accounts  in  the  same  way,  and  as  it  is  becoming  the 
custom  of  many  clubs  to  require  all  payments  to  be  made  at 
the  office,  very  little  difficulty  should  be  experienced  in  enforc- 
ing the  rule  of  payment  by  cheque. 

In  connection  with  the  bar,  also,  the  accounts  of  clubs  pre- 
sent an  advantage  over  those  employed  by  many  hotels,  viz., 
that  all  orders  for  drinks  have  (frequently)  to  be  signed  by 
the  member,  and  are  thus  available  as  vouchers  for  verifying 
the  taking  of  wines  and  spirits  out  of  stock.  It  may  be  added, 
however,  that  this  is  a  system  which  is  used  by  a  considerable 
number  of  hotels,  although  many  dispense  with  it  on  the  ground 
that  it  is  difficult  to  get  their  customers  to  take  the  necessary 
trouble.  In  clubs,  where  the  orders  are  returned  to  the  mem- 
bers monthly  after  payment  of  their  accounts,  carbon  sheets 
are   frequently  used  and  duplicate  orders  obtained. 

Another  system  is  that  of  ticket  books,  everything  bought 
by  members  to  be  prepaid  therefrom.  It  saves  bookkeeping — 
no  personal  accounts  being  necessary — and  has  much  to  com- 
mend it. 

In  connection  with  hotels,  restaurants  and  clubs  there  are — 
or  ought  to  be — miscellaneous  receipts  from  various  sources, 
such  as  the  sale  of  bones,  fat,  &c.,  from  the  kitchen  and  the 
like.  In  some  establishments,  the  receipts  from  the  sales  of 
offal  are  considered  perquisites  of  the  chef,  but  such  a  system 
is  bad,  as  all  compensation  of  employees  should  pass  through 
the  payroll.  It  is  extremely  difficult,  if  not  well  nigh  impos- 
sible in  some  cases,  to  be  certain  that  all  such  receipts  have 
been  properly  accounted  for.  The  entire  absence  of  them 
should,  however,  arouse  suspicion,  and  it  is  well  to  compare  the 


THEATRES.  lOI 

amounts  received  during  one  period  with  receipts  during  pre- 
vious periods. 

(h)  THEATRE  ACCOUNTS,  &c.— The  most  difficult 
feature  in  theatrical  and  similar  accounts  (from  the  auditor's 
point  of  view)  is  the  large  amount  of  cash — i.  e.,  currency  and 
coin — which  is  necessarily  handled  by  all  persons  connected 
with  the  financial  part  of  the  management.  It  is  to  be  regretted 
that  managers  cannot  be  induced  to  make  their  payments  by 
cheque  more  generally,  although  the  practice  is  gradually  in- 
creasing in  this  country. 

An  auditor,  must,  however,  above  all  things,  be  practical; 
and  it  is,  therefore,  well  to  face  the  situation  at  once,  and  do 
his  best  with  the  existing  cash  system,  for  he  may  rest  assured 
that  no  amount  of  "  representation  "  upon  his  part  will  induce 
managers  to  make  all  their  payments  by  cheque,  while  it  is,  of 
course,  quite  impossible  that  their  receipts  should  be,  to  any 
great  extent,  in  anything  but  currency. 

It  is  not  usual  for  the  auditor  to  be  expected  to  verify  the 
cash  receipts ;  this  is  usually  performed  by  the  treasurer,  who 
is  considered  a  sufficiently  responsible  person  for  the  perform- 
ance of  a  function  that  requires  integrity  certainly,  but  no 
great  technical  knowledge. 

Theatre  accounts  differ  so  widely  from  ordinary  commercial 
accounts  that  a  brief  description  of  their  methods  is  in  order 
before  we  consider  the  question  of  audit.  The  treasurer 
makes  up  a  daily  statement  as  follows:  About  half  an  hour 
after  the  beginning  of  each  performance  the  treasurer  of  the 
theatre  counts  his  unsold  coupon  tickets  and  makes  up  a 
"  rough  "  statement  of  the  cash  which  should  be  on  hand ;  to 
this  he  adds  the  proceeds  of  sales  of  "  hard  "  tickets  (general 
admission  and  exchange)  and  he  then  submits  this  statement 
to  the  treasurer  of  the  company.  The  two  treasurers  then 
count  the  tickets  contained  in  the  doortenders'  boxes,  which, 
except  in  stormy  weather,  agree  very  closely  with  the  rough 


I02  AUDITING. 

statement.     After  the  count  the  theatre  treasurer  makes  out  a 
final  statement,  which  is  signed  by  both  treasurers. 

At  the  end  of  each  week  the  theatre  treasurer  makes  up  a 
"  settlement  sheet,"  which  shows  the  gross  receipts,  and  the 
share  of  same  due  to  the  theatre.  To  this  are  added  any  ad- 
ditional earnings,  and  after  deducting  the  salaries  and  petty 
expenses,  he  pays  the  remainder,  in  currency,  to  the  manager. 
The  latter  usually  pays  all  advertising,  bill  posting,  light,  &c., 
about  Tuesday  of  each  week  to  cover  the  previous  week.  In 
some  theatres  the  treasurer  pays  all  bills  and  settles  with  the 
manager  for  the  profit  or  loss  shown  by  the  weekly  statements 
only,  but  this  is  unusual. 

The  treasurer  of  the  theatre  also  prepares  a  complete  weekly 
statement  for  the  company  treasurer,  and  settles  therefor. 
After  making  these  two  settlements  he  would  have  on  hand 
only  the  receipts  of  the  "  advance  sale  " ;  this  is  an  important 
item  sometimes,  and  will  be  considered  again  further  on. 

The  object  of  theatre  bookkeeping  is  to  show  the  profit  or 
loss  of  each  week's  business  so  as  to  determine  which  attrac- 
tions pay  best.  It  is,  therefore,  usual  to  apportion  such  items 
as  the  annual  license  fee,  rent,  repairs,  &c.,  weekly  on  a  basis 
of  a  season  of  thirty  or  thirty-five  weeks. 

With  the  foregoing  in  mind  the  audit  of  theatre  accounts 
will  be  a  simple  matter,  and  should  be  made  somewhat  as  fol- 
lows: 

Count  the  coupon  tickets  in  the  rack  and  deduct  the  number 
on  hand  from  the  total  capacity  of  the  house ;  secure  a  state- 
ment of  "  hard  "  tickets  furnished  treasurer  at  beginning  of 
season,  deduct  number  on  hand  at  time  of  balancing,  and  the 
remainder  must  be  accounted  for  in  cash.  The  total  result 
should  then  agree  with  the  cash  and  vouchers  in  the  hands  of 
the  treasurer. 

See  that  all  niglitly  statements  during  period  covered  by 
audit  are  signed  by  the  treasurers  of  the  companies.       Com- 


THEATRES.  IO3 

pare  contracts  with  managers'  settlements  to  ascertain  that  re- 
ceipts have  been  properly  divided,  and  that  the  proper  shares 
of  "  extras  "  have  been  collected  from  companies. 

Call  for  properly  authorized  vouchers  for  all  payments.  The 
vouching  of  payments  resolves  itself  upon  the  lines  ordinarily 
adopted  in  trading  concerns;  and  here — as  elsewhere — it  is 
not  the  least  important  of  the  auditor's  functions  to  inquire 
into  the  manner  in  which  the  pay-rolls  are  prepared.  It  need 
hardly  be  stated  that  all  persons  entering  the  premises  before  a 
performance  sign  an  "  Attendance  Book  "  kept  at  the  stage 
door  for  that  purpose,  and  that  fines  for  absence  or  lateness  are 
arrived  at  from  this  source.  It  is  not  usual  for  the  auditor  to 
verify  the  composition  of  the  pay-rolls,  but  there  would  be  no 
harm  done  if  he  did  so  occasionally — and  unexpectedly. 

It  will  be  easy  to  suggest  improvements  in  the  methods  gen- 
erally found  in  force,  but  it  will  be  almost  impossible  to  secure 
any  changes.  One  of  the  greatest  difficulties  in  theatre  ac- 
-counting  is  to  divide  the  responsibility  of  the  treasurer  and 
his  assistant.  They  both  have  access  to  the  same  cash,  and, 
as  it  takes  an  expert  at  least  an  hour  to  count  a  rack,  it  will 
be  seen  that  one  cannot  balance  to  the  other  as  hotel  clerks 
do  when  they  change  watch.  The  same  difficulty  arises  in  con- 
nection with  the  weekly  payments  to  the  manager.  After  mak- 
ing settlement  with  him  the  cash  remaining  represents  the 
advance  ticket  sales,  which,  of  course,  should  be  verified  at  the 
time.  Owing  to  the  difficulty  of  counting  a  large  number  of 
tickets,  managers  seldom  do  it,  and  more  than  one  defalcation 
has  been  carried  along  by  means  of  using  the  proceeds  of  ad- 
vance sales  to  cover  up  shortages. 

In  "  continuous  performance  "  houses  most  of  the  admis- 
sions are  "  strip  "  tickets,  which  are,  of  course,  easily  counted. 

(i)  THEATRICAL  COMPANIES.— The  audit  of  the  ac- 
counts of  a  company  should  be  quite  a  simple  matter,  but 
owing  to  the  conditions  under  which  a  company  treasurer 


104  AUDITING. 

usually  works,  his  books  and  accounts  will  be  in  a  more  or 
less  unsatisfactory  state. 

In  any  event,  he  should  be  required  to  keep  a  cash  book 
and  balance  it  at  least  once  a  week. 

With  this  as  a  basis  it  will  be  comparatively  simple  to  build 
up  what  are  generally  known  as  "Production''  accounts,  which 
may  be  classified  as  follows : 

Preliminary  Expenses. — Covers  all  expenses  incurred 
during  rehearsals,  such  as  stage  manager's  salary,  musical  di- 
rector's salary,  typewriting  parts,  orchestra,  rent  of  hall,  &c. 

Scenery. — This  is  usually  built  by  one  firm,  but  it  may  be 
painted  by  different  artists.  A  certain  high-priced  artist  may 
be  engaged  to  paint  a  difficult  landscape,  but  the  painting  of 
a  simple  interior  would  be  given  to  a  cheaper  man.  The  work 
of  building  and  painting  is  nearly  always  done  under  contract 
and  payments  made  at  specified  times. 

Properties. — This  item  includes  almost  everything  used  in 
the  stage  representation  which  could  not  be  classified  as  scen- 
ery, costumes,  or  electrical  apparatus.  It  includes  furniture, 
draperies,  artificial  flowers,  spears,  animals  (either  papier 
mache  or  alive).  Perishable  properties  are  not  charged  to 
production,  but  to  current  expenses. 

Costumes. — This  item  includes  hats,  wigs,  shoes,  &c. 

Electrical  Apparatus. — This  covers  calcium  lamps,  special 
devices,  &c.,  and  is  sometimes  a  very  large  item.  Some  com- 
panies rent  the  electrical  equipment ;  the  rental  is  then  charged 
to  current  expenses. 

The  company's  profit  and  loss  account  is  also  made  up  weekly 
to  accord  with  the  theatre  accounts.  An  audit  would  consist 
largely  in  checking  the  receipts  by  comparison  with  the  nightly 
statements  signed  by  the  house  treasurer;  seeing  that  all  fines 
imposed  by  the  stage  manager  have  been  collected;  examin- 
ing the  contracts  and  securing  proper  vouchers. 


PUBLISHERS.  lOS 

Theatrical  productions  are  so  uncertain  in  their  outcome  that 
no  rule  for  dealing  with  the  question  of  depreciation  can  be 
laid  down.  Obviously  the  copyright  of  a  successful  play  is 
an  asset  which  does  not  depreciate  rapidly  in  value,  while  the 
total  cost  of  an  unsuccessful  production  must  be  written  off 
at  once.  It  is  stated  on  good  authority  that  the  entire  cost 
of  production  is  charged  off  against  the  first  year's  business 
by  all  of  the  New  York  managers.  Each  undertaking  should, 
therefore,  be  considered  with  respect  to  the  usual  custom,  pro- 
vided it  is  conservative. 

(;)  PUBLISHERS.— The  audit  of  publishers'  accounts 
presents  a  peculiar  combination  of  complications.  In  many 
cases  publishers  will  do  their  own  printing,  and  in  this  respect 
they  follow  the  rules  of  manufacturing  traders.  (See  under 
heading  1.  (b)  above.)  Almost  invariably,  however,  they  will 
also  be  retailers,  and  hence  the  considerations  detailed  under 
heading  I.  (c)  will  also  apply.  Many  houses  add  the  further 
occupation  of  trading,  either  wholesale  or  retail,  or  both,  in  the 
publications  of  other  firms,  which,  to  a  great  extent,  brings 
them  under  the  heading  I.  (a)  above ;  while  almost  every  house 
will  occasionally  undertake  the  publication  of  authors'  works 
upon  such  terms,  as  to  royalty,  &c.,  as  make  it  absolutely 
necessary  that  both  stock  accounts  and  cost  accounts  should 
be  carried  to  perfection.  In  this  respect  publishers'  accounts 
involve  many  of  the  considerations  discussed  under  heading  I. 
(d)  when  dealing  with  Contractors'  Accounts. 

A  complete  audit  of  publishers'  accounts  is  on  account  of 
the  multiplicity  of  detail  involved  a  practical  impossibility ;  the 
extent  to  which  a  partial  audit  may  advantageously  be  carried 
must,  on  the  other  hand,  of  necessity,  vary  with  almost  every 
individual  case.  The  considerations  involved  in  the  previous 
paragraphs  are  the  only  ones  that  can  be  offered;  but  it  may 
be  added  that  here — as  in  the  case  of  all  other  partial  audits — 
the  precise  routine  may  be  varied  from  time  to  time  with  the 
greatest  advantage. 


I06  AUDITING. 

Permanent  assets,  such  as  buildings,  plant,  &c.,  must,  of 
course,  be  subjected  to  proper  depreciation,  and  stock-in-trade 
will  require  careful  valuing.  It  ought  to  be  possible  for  the 
auditor  to  obtain  absolute  proof  as  to  the  quantity  of  stock- 
in-trade,  but  he  can  hardly  be  expected  to  check  the  inventory 
in  extenso.  The  prices  set  upon  unsold  publications  should 
never  exceed  the  cost  of  production. 

Care  should  be  taken  to  ascertain  that  the  stock  list  is  not 
unduly  inflated  by  almost  entire  editions  of  absolutely  unsal- 
able publications  that  are  not  worth  anything  like  the  cost  of 
production. 

With  regard  to  the  valuation  of  copyrights  for  balance  sheet 
purposes,  it  is  usual  for  a  separate  account  to  be  opened  for 
each  publication,  which  is,  in  the  first  place,  debited  with  the 
actual  cost  of  production,  including,  of  course,  the  printing, 
binding,  illustrations,  &c.  (and,  where  the  copyright  is  pur- 
chased the  purchase-price  thereof,  together  with  that  of  any 
stock  which  may  have  been  taken  over  therewith.)  Many 
firms  at  balancing  time  review  the  debits  to  the  various  copy- 
right accounts,  depreciating  some  and  appreciating  others; 
that  is  to  say,  the  system  is  adopted  of  valuing  the  copyrights 
by  inventory  at  each  period  of  balancing,  wholly  irrespective 
of  the  actual  cost.  It  is,  of  course,  very  desirable  that  where 
necessary  the  cost  should  be  written  down  from  time  to  time ; 
but  the  arguments  with  regard  to  the  writing  up  the  value  of  a 
copyright  are  precisely  those  which  might  be — and,  indeed, 
should  be — invariably  used  against  writing  up  the  value  of  the 
asset  goodwill  and  crediting  the  difference  to  profit  and  loss 
account.  It  may  be  perfectly  true  that  a  large  revenue  is 
expected  from  this  asset  in  the  future ;  but  that,  in  itself,  can 
afford  no  possible  argument  for  anticipating  that  revenue,  and 
taking  credit  for  it  in  the  current  period.  On  the  other  hand, 
it  will  probably  be  generally  admitted  that  no  great  harm  can 
be  done  by  writing  up  such  copyrights  as  have  appreciated 
so  long  as  the  actual  effect  of  so  doing  is  not  to  increase  the 
book-value  of  copyrights  as  a  whole.     In  this  connection,  it 


PUBLISHERS.  107 

may  be  mentioned  that  with  many  houses  there  is  a  good  gen- 
eral rule  in  use,  to  the  effect  that  the  value  attached  to  any 
copyright  should  not  exceed  three  years'  purchase  upon  the 
gross  profit  earned  therefrom  during  the  past  year. 

Sometimes,  even  when  a  publication  is  itself  a  failure,  some 
residual  value  will  attach  to  illustrations,  &c.,  which  have  been 
used  in  its  production.  It  is  very  important,  however,  that  no 
fictitious  estimate  should  be  put  upon  the  value  of  such  doubt- 
ful assets  as  these,  and  of  the  two  it  seems  infinitely  preferable 
that  they  should  be  stated  at  nil  in  the  balance  sheet. 

The  value  of  artists'  original  drawings  (for  illustrations) 
is  often  considerable,  and  has  not  infrequently  been  found  to 
exceed  the  price  originally  paid  for  both  original  and  copy- 
right. It  is  hardly  safe,  however,  to  reckon  such  originals  as 
assets — if  valuable,  they  will  generally  be  sold,  and  if  retained, 
the  most  that  can  be  said  is  that  they  have  a  latent  value. 

It  is  unfortunately  the  custom  in  many  large  publishing 
houses  in  the  United  States  to  carry  their  plates  at  cost,  or 
with  a  very  small  allowance  for  depreciation.  No  matter  how 
successful  the  publication  may  be,  it  should  always  be  borne 
in  mind  that  every  book  turned  out  will  have  to  bear  a  pro- 
portionate share  of  the  costs  of  all  the  plates.  The  failure  of 
more  than  one  publisher  has  been  traced  to  this  omission. 

On  behalf  of  his  clients  it  may  be  thought  desirable  for  the 
auditor  to  thoroughly  check  all  royalty  accounts,  but  this  does 
not  form  part  of  a  regular  audit. 

Newspapers  and  magazines  present  several  special  features. 
In  the  absence  of  a  staff-auditor,  the  auditor  will  require  to 
satisfy  himself  that  every  advertisement  is  eventually  paid  for 
(unless,  of  course,  a  bad  debt  has  been  made),  or  else  that  it 
has  been  franked  as  "  free  "  by  some  responsible  person.  The 
commission  accounts  of  agents  and  canvassers  should  also 
always  be  examined. 

In  the  case  of  a  monthly  magazine,  at  least  two  numbers 
out  of  twelve  should  be  selected  and  checked  thoroughly  to 


I08  AUDITING. 

see  that  every  advertisement  is  accounted  for.  A  certain  por- 
tion of  the  contracts  should  also  be  checked  into  the  adver- 
tising register,  as  it  very  often  happens  that  this  book  is  kept 
by  a  clerk  in  the  advertising  department  who  does  not  appre- 
ciate the  importance  of  accuracy. 

The  subscriptions  will  be  more  difficult  to  verify.  Usually, 
however,  great  care  is  taken  to  secure  a  good  internal  check, 
and  the  system  should  be  looked  into  carefully.  It  is  needless 
to  say  that  the  clerks  in  charge  of  the  subscription  cards  and 
records  should  not  have  access  to  the  cash.  The  balance  sheet, 
must,  of  course,  contain  a  reserve  for  unfilled  subscriptions, 
although  most  publishers  do  not  provide  such  an  account. 

The  "  inside  "  of  a  paper  is  the  work  of  the  regular  staff, 
or  of  "  contributors  " ;  the  former  are  usually  paid  a  regular 
salary,  the  latter  are  paid  for  the  actual  work  done.  It 
would  be  a  desirable  thing  to  make  sure  that  a  contributor  was 
never  paid  for  a  sub-editor's  work,  but  no  auditor  could  ever 
ascertain  such  a  thing  for  himself,  and  he  must  therefore  rest 
content  with  the  certified  contributors'  accounts  as  they  are 
submitted  to  him. 

It  frequently  devolves  upon  the  auditor  to  prepare  weekly, 
or  monthly,  statements,  showing  approximately  the  income 
and  expenditure.  Such  work  naturally  commands  a  special 
fee. 

The  printing  of  the  publication  calls  for  no  special  comment 
here;  when  done  by  the  proprietors  they  will,  of  course,  be 
printers,  as  well  as  publishers,  and  the  auditor  must  take  his 
stand  accordingly. 

The  number  of  copies  printed,  issued,  returned,  exchanged, 
distributed  free,  and  in  stock,  should  always  be  certified  by  the 
publishing  manager.  From  his  returns  the  individual  ledger 
debits  may  be  vouched. 

The  Post  Office  returns,  or  vouchers,  for  second-class  post- 
age are  a  good  check  on  the  total  circulation  of  a  periodical. 


MINES.  109 

Every  periodical  is  started  at  a  loss,  and  it  is  usual  to  debit 
this  loss  to  an  Establishment  Account;  when  the  concern  pays 
— and  so  acquires  a  goodwill — the  cost  of  such  goodwill  is 
represented  by  the  amount  to  the  debit  of  Establishment  Ac- 
count, which  thus  virtually  becomes  a  Goodwill  Account.  There 
is  no  great  objection  to  this  system,  and  it  is  much  in  favor 
on  account  of  the  information  it  afford  to  the  intending  pur- 
chaser of  a  recently  established  paper;  but,  when  a  periodical 
is  once  fairly  started,  the  auditor  should  require  a  very  good 
reason  to  be  furnished  him  before  he  sanctions  the  transfer  of 
an  unexpected  loss  to  the  Establishment  Account ;  if  such  loss 
arises  from  an  increase  of  matter  (in  quantity  or  quality)  or  a 
reduction  in  price,  it  may  be  in  the  nature  of  capital  outlay,  as 
tending  to  increase  the  permanent  value  of  the  concern,  but  an 
unexpected  loss  is  likely  to  have  the  contrary  effect. 


II.     MINING    ACCOUNTS 

(a)  COAL  MINES. — Better  advice  can  hardly  be  given 
to  the  accountant  who  is  about  to  audit  the  accounts  of  a 
mine  for  the  first  time  than  to  suggest  that  he  should  make  a 
tour  of  the  whole  works  (both  above  and  below  ground)  in 
company  with  the  colliery  manager.  If  he  be  of  an  observant 
turn  of  mind  he  will  probably  by  the  end  of  his  inspection, 
have  formed  at  least  some  idea  of  the  scope  of  the  undertaking, 
and  he  will  doubtless  find  that  the  gloom  of  the  underworld 
has  thrown  considerable  light  upon  the  records  kept  above 
ground.  Even  the  auditor  experienced  in  colliery  accounts 
will  probably  find  that  the  thorough  inspection  of  a  new  mine 
is  really  a  wise  economy  of  time ;  in  fact,  whatever  the  nature 
of  the  business  may  be,  the  auditor  who  acquaints  himself 
with  the  manner  in  which  it  is  carried  on  does  wisely. 

A  question  of  particular  importance  in  these  accounts  is  the 
treatment  of  the  capital  expenditure  account.  Great  care 
must  be  taken  to  see  that  no  expenditure  properly  chargeable 
against  revenue  is  included  herein — indeed,  it  is  always  de- 


no  AUDITING. 

sirable  to  get  the  capital  expenditure  account  altogether  closed 
as  quickly  as  possible. 

Some  mining  companies,  in  calculating  the  cost  per  ton  of 
the  ore  extracted,  include  the  expense  of  dead  work,  develop- 
ment, exploration,  &c.,  while  many  others  state  as  the  cost 
of  extraction  work  the  actual  expenditure  for  stoping  and 
hoisting  only,  treating  the  development  work,  especially  in  shaft 
sinking,  as  a  capital  expenditure. 

The  item  "  Minimums  paid  in  excess  of  royalties  earned," 
which  frequently  occurs  as  an  asset  in  the  accounts  of  young 
collieries,  requires  some  little  explanation.  The  royalty  pay- 
able is  based  upon  the  quantity  extracted — usually  upon  the 
number  of  tons,  but  sometimes  upon  the  number  of  cubic 
yards,  or  the  acreage  of  the  seams  worked — a  fixed  "minimum'* 
royalty  being  payable  in  any  event,  whether  the  mines  are 
worked  or  not.  During  the  sinking  of  the  shafts  and  first 
working  of  the  mine,  therefore,  the  royalty  paid  naturally  ex- 
ceeds the  normal  percentage  upon  the  output.  Under  ordi- 
nary circumstances  tjiis  would  represent  a  charge  against  Rev- 
enue in  the  usual  way;  but,  as  the  lessees  are  empowered  to 
recoup  themselves  out  of  subsequent  production,  it  is  quite 
justifiable  that  the  excess  so  paid  at  first  should  be  carried  for- 
ward as  a  set-off  against  the  output  of  later  years.  It  is  very 
necessary,  however,  that  the  auditor  should  examine  the  consti- 
tution of  the  amount  so  carried  forward.  It  not  infrequently 
happens  that  the  mine  as  a  whole  is  comprised  of  several  leases, 
some  of  which  are  not  being  worked,  and  never  will  be ;  the 
minimum  royalty  upon  such  portions  ought,  of  course,  to  be 
charged  against  Revenue  each  year,  and  where,  in  the  early 
days  of  the  colliery's  existence,  an  accumulation  of  such  mini- 
mums  has  been  allowed  to  be  carried  forward,  it  must  be  writ- 
ten off  as  soon  as  possible.  Again,  there  is  often  a  limit  to 
the  time  during  which  advance  royalties  may  be  recouped,  and 
this  limit,  of  course,  must  not  be  exceeded.  It  need  hardly 
be  added  that  the  only  justification  for  treating  the  whole — 


MINES.  Ill 

or  any  portion — of  the  balance  of  this  account  as  an  asset  is  the 
reasonable  probability  that  it  will  be  redeemed  out  of  future 
production  within  the  time  limit  allowed  by  the  lease. 

The  question  of  depreciation  upon  mines  is  naturally  one 
of  no  slight  importance;  but  it  is  not  certain  that — however 
desirable  it  may  be  that  an  adequate  provision  should  be  made 
for  depreciation  arising  either  from  the  exhaustion  of  minerals, 
or  from  the  lapse  of  the  lease,  or  from  both — it  is  legally  neces- 
sary for  a  mining  company  to  set  aside  any  portion  of  its  earn- 
ings to  replace  wasting  capital.  The  auditor  can  thus  do  no 
more  than  advise  the  extreme  desirability  of  so  prudent  a 
course. 

Many  mortgages  upon  coal  and  ore  lands  require  a  sinking 
fund  to  be  established  to  cover  exhaustion,  usually  at  a  fixed 
rate  per  ton.  Here,  of  course,  the  accounts  must  be  con- 
structed accordingly,  and  a  careful  reading  of  all  mortgages 
will  be  required. 

Unfortunately,  sinking  fund  provisions  in  mortgages  are 
not  always  entirely  clear.  They  are  almost  invariably  written 
by  lawyers,  who  rarely  consider  the  matter  in  connection  with 
the  accounts  of  the  undertaking. 

For  instance,  where  a  clause  in  a  mortgage  on  coal  lands 
requires  the  setting  aside  of  five  cents  per  ton  on  all  coal 
"  shipped,"  a  diflference  of  opinion  can  easily  arise  over  the 
question  as  to  whether  the  coal  consumed  in  the  company's 
own  operations  both  at  the  mines  and  in  transit  should  be  pro- 
vided for.  If  the  provision  was  based  on  probable  exhaustion, 
certainly  every  ton  produced  must  be  taken  into  account,  but 
if  the  original  intention  was  to  cover  sales,  no  payment  to  the 
sinking  fund  would  be  required  therefor. 

Subsequent  dififerences  of  this  nature  would  not  arise  if 
more  attention  were  given  to  the  wording  of  these  provisions. 

In  this  connection  it  will  be  of  interest  to  note  the  following 
extract  from  "  The  Profits  of  a  Corporation,"  by  A.  Lowes 


112  AUDITING. 

Dickinson,  F.  C.  A.,  C.  P.  A.  (paper  read  at  the  St.  Louis  Con- 
gress of  Accountants,  1904) : 

"  In  the  case  of  minerals,  the  product  taken  out  of  the  land  becomes 
the  stock-in-trade  of  a  corporation  as  soon  as  it  is  extracted,  and 
whatever  the  land  was  worth  before  its  extraction  it  is  clearly  worth 
an  appreciable  amount  less  thereafter.  The  provision  to  be  made 
should  be  on  the  basis  of  the  number  of  tons  extracted,  having  regard 
to  the  total  tonnage  available  and  to  the  realizable  value  of  the  prop- 
erty after  the  minerals  have  all  been  extracted.  The  same  principle 
would  also  apply  to  timber  lands,  where  no  provision  is  made  for  re- 
foresting. The  contention  is  sometimes  made  that  no  provision  need 
be  made  for  exhaustion  of  minerals  where  the  amount  of  mineral 
known  to  be  in  a  definite  tract  at  the  end  of  any  period  is  largely  in 
excess  of  that  which  had  been  discovered  at  the  beginning  of  the 
period.  This  argument  cannot,  however,  for  a  moment  be  admitted 
except  as  a  reason  for  reducing  the  tonnage  rate  to  be  provided.  As 
a  general  principle,  whatever  there  was  in  the  land,  whether  known 
or  unknown,  has  been  reduced  during  the  period  under  consideration 
by  whatever  amount  has  been  extracted ;  and  while  the  new  discoveries 
may  be  accepted  as  reducing  the  necessary  rate  of  provision  for  ex- 
tinction from  (say)  one  dollar  to  one  cent  per  ton,  the  original  prin- 
ciple that  provision  must  be  made  holds  good  on  the  smaller  figure, 
whatever  it  is.  It  may  be,  of  course,  that  the  provisions  made  in  ear- 
lier years  have  been  sufficient  to  cover  a  number  of  future  years  on 
the  basis,  from  the  commencement,  of  the  rate  subsequently  found  to 
be  sufficient  in  view  of  the  new  discoveries,  and  in  this  case  there  is 
obviously  no  necessity  to  provide  further  for  extinction  until  the  total 
production  at  the  new  rate  is  equal  to  the  total  amount  written  off." 

Usually  mining  companies  own  the  cottages  occupied  by 
their  employees,  and  this  matter  will  require  the  auditor's  at- 
tention. Rents  receivable,  however,  have  already  been  con- 
sidered. 

(b)  GOLD  MINES,  &c.— The  services  of  an  auditor  are 
frequently  required  in  connection  with  gold,  silver,  copper, 
and  other  mining  enterprises  carried  on  in  the  far  West. 
Usually  the  services  consist  in  ascertaining  for  dissatisfied 
creditors  or  stockholders  just  where  the  cash  capital  has  been 
sunk,  in  which  case  it  is  rather  of  the  nature  of  an  investigation 
than  an  audit.  It  sometimes  happens,  however,  that  ore  is 
actually  found  in  paying  quantities,  and  the  question  then 


MINES.  113 

arises  as  to  how  far  the  mine  manager's  accounts  can  be  ac- 
cepted. He  usually  remits  periodically  a  statement  of  his 
receipts  and  payments,  which  is  incorporated  in  the  accounts 
kept  at  head  office.  Such  accounts  are  not  usually  very  volu- 
minous, and  are  generally  examined  by  the  auditor  in  extenso. 
It  is,  of  course,  desirable  that  all  expenditure  at  the  works  be 
properly  vouched,  and  for  the  auditor  to  examine  these 
vouchers. 

For  balance  sheet  purposes  the  mine  manager  should  be 
required  to  apportion  all  expenditure  between  capital  and 
revenue,  and  to  certify  such  apportionment;  also  to  submit  a 
certified  statement  of  local  floating  assets  and  liabilities,  or  a 
certificate  that  no  such  assets  or  liabilities  exist  locally,  and 
at  the  same  time  he  should  report  upon  the  state  of  efficiency 
of  the  plant  and  machinery,  together  with  any  buildings  and 
other  more  or  less  permanent  assets  there  may  be  upon  the 
works.  This  latter  report  is  most  essential  for  a  proper  con- 
sideration of  the  question  of  depreciation. 

It  is  always  well — and  where  the  produce  of  the  mine  is 
precious,  it  is  very  essential — for  the  auditor  to  use  every 
available  means  of  ascertaining  that  credit  has  been  taken  in 
the  books  for  the  value  of  the  whole  of  the  output. 

Depreciation  of  plant  should,  of  course,  be  provided  for; 
but  that  question  is  best  dealt  with  in  a  later  chapter. 

The  wages  paid  by  mining  companies  require  the  same  care- 
ful attention  that  must  at  all  times  be  accorded  to  this  most 
important  item;  but  inasmuch  as  the  great  bulk  of  wages  paid 
is  at  the  rate  of  so  much  per  ton,  the  aggregate  amount  pay- 
able can  be  tested  with  greater  facility  than  in  many  other 
cases. 

The  peculiar  conditions  obtaining  to  mining  accounts  gen- 
erally render  it  desirable  that  the  audit  should  descend  into 
somewhat  considerable  detail;  concerning  the  actual  extent 
of  such  detail,  however,  no  general  rules  can  be  given,  as 


114  AUDITING. 

each  case  must  be  judged  upon  its  own  merits.  Great  care 
should  be  taken  to  sec  that  no  expenses  are  capitalized  that 
are  not  bona  fide  of  a  "  capital "  nature. 

In  conclusion,  it  may  be  added  that  the  auditor  should  ex- 
pressly state  in  his  report  what  the  precise  extent  of  his  exam- 
ination has  been. 

III.     FINANCIAL    ACCOUNTS. 

(fl)  BANKS. — In  dealing  with  the  question  of  bank  audits, 
it  is  well  to  remember  that  one  of  the  most  controversial  sub- 
jects relative  to  professional  practice  is  being  discussed.  So 
far  as  possible,  a  position  that  few  will  care  to  assail  will  be 
occupied;  but  it  were  well  to  admit  at  once  that  the  authors 
consider  the  duties  of  a  bank  auditor  to  be  very  much  more 
onerous  than  some  eminent  accountants  care  to  admit,  what- 
ever his  bare  legal  responsibilities  may  be.  It  is  not  necessary 
to  criticise  the  motives  that  have  dictated  the  position  taken 
by  some  of  the  leading  members  of  the  profession;  but  it  is 
difficult  to  see  the  force  of  an  argument  that  virtually  amounts 
to  the  assertion  that  the  mere  multiplicity  of  a  series  of  state- 
ments is  a  valid  reason  for  not  inquiring  into  the  accuracy 
of  those  statements.  Further,  it  is  to  be  remembered  that  the 
bare  legal  responsibility  is  not  the  highest  measure  of  the 
duties  of  a  professional  man.  It  is  certainly  very  desirable 
that  the  law  should  not  be  unduly  harsh — or  the  position  of  an 
auditor  would  be  intolerable — ^but  it  is  imagined  that  few 
would  consider  that  they  had  discharged  all  moral  obligations 
when  they  had  complied  with  their  legal  duties.  These  re- 
marks, however,  apply  equally  to  all  classes  of  audits. 

The  inference  must  not  be  drawn,  however,  that  the  authors 
consider  that  a  bank  audit  is  fundamentally  difficult,  or  that 
it  requires  special  knowledge  of  an  extraordinary  sort;  on 
the  contrary,  it  can  be  successfully  maintained  that  a  general 
practitioner  of  wide  practice  is  better  qualified  to  audit  the 
accounts  of  a  bank  than  one  who  devotes  his  entire  attention 


BANKS  115 

to  this  class  of  work.  In  the  latter  case  the  mere  familiarity 
with  the  usual  books  and  methods  tends  to  narrow  one's  vision, 
and  a  bank  examiner  is  apt  to  fall  into  a  rut.  After  all,  the 
theory  of  a  bank  audit  is  very  much  like  that  of  any  other 
audit,  and  the  same  careful  study  of  a  bank's  statement  which 
an  auditor  must  pay  to  the  balance  sheet  of  a  manufacturing 
concern  will  indicate  to  him  the  scope  of  the  audit,  and  after 
one  or  two  experiences  he  need  expect  no  trouble. 

In  all  cases  the  auditor  should  secure  the  most  recently  pub- 
lished statement  of  the  bank  whose  accounts  he  expects  to 
examine,  and  a  general  scrutiny  of  the  several  asset  and  lia- 
bility items  will  reveal  far  more  of  what  he  has  before  him  than 
in  almost  any  other  work  he  undertakes. 

Under  our  National  Banking  Act,  compulsory  examinations 
are  made  by  examiners  in  government  employ,  and  while  in  the 
past  they  have  rendered  valuable  service,  and  many  of  them 
are  auditors  in  the  highest  sense  of  the  word,  it  must  be  re- 
membered that  their  chief  duty  is  to  see  that  a  bank  is  solvent 
and  complying  with  law,  and  this  accounts  for  the  large  num- 
ber of  minor  defalcations  which  they  never  discover.  Owing 
to  the  insufficient  time  which  is  allotted  to  each  bank,  it  is  a 
physical  impossibility  for  them  to  cover  the  ground  thoroughly, 
and  it  is  no  longer  a  rarity  to  hear  of  bank  defalcations  which 
have  been  going  on  under  the  eyes  of  the  national  bank  ex- 
aminers for  twelve  to  fifteen  years. 

For  these  reasons  bank  directors  are  gradually  coming 
around  to  the  feeling  that  it  is  their  duty  to  have  more  thor- 
ough audits,  and  naturally  the  work  falls  to  the  Certified  Pub- 
lic Accountant,  and  it  is  very  satisfactory  to  note  that  several 
State  bank  examiners  have  made  recommendations  to  this 
effect. 

The  certification  of  a  bank  balance  sheet  involves  the  thor- 
ough examination  and  exhaustive  testing  of  every  account  in 
the  general  ledger,  the  counting  of  the  balance  of  cash  in  hand,, 
the  examination  of  all  notes  (especial  care  being  taken  to  note 


Il6  AUDITING. 

that  all  overdue  notes  are  properly  explained)  and  the  inspec- 
tion of  all  securities — whether  owned  by  the  bank  or  held  as 
collateral  for  borrowers.  With  regard  to  the  counting  of  the 
cash  balance,  the  only  safe  way  of  dealing  with  cheques  in 
hand  is  for  the  auditor  to  himself  forward  them  to  the  clear- 
ing house  and  other  agents,  or  where  this  is  impracticable,  to 
secure  direct  confirmation  of  the  clearing  house  returns.  The 
disregard  of  this  precaution  has  left  the  door  open  for  most 
serious  frauds  upon  the  part  of  bank  managers  and  others. 

The  counting  of  the  cash  in  a  large  bank  is  very  hard  physi- 
cal work,  to  say  nothing  of  mental  strain.  As  the  securities 
and  collaterals  should  be  taken  up  the  same  day,  it  is  useless 
for  an  auditor  to  undertake  this  work  unless  he  has  a  staff 
of  reliable  men,  some  of  whom  should  have  had  previous  ex- 
perience in  counting  cash  and  handling  securities.  Not  less 
than  five  or  six  men  will  be  needed  the  first  day  in  a  fairly  large 
bank,  but  after  (say)  the  second  day  the  force  can  be 
decreased. 

It  hardly  seems  necessary  to  urge  the  importance  of  making 
the  audit  without  notice  to  any  one,  and  this  means  the  officers 
and  directors  as  well  as  the  tellers  and  other  clerks. 

The  work  of  counting  the  cash  and  examining  the  securities 
can  be  commenced  early  in  the  afternoon  by  taking  up  the  re- 
serves first,  and  working  down  to  the  settlements.  The  staff 
should  be  so  distributed  and  instructed  that  any  transfers  from 
one  teller  to  the  other,  or  sending  out  for  cash  to  conceal  a 
defalcation,  would  be  immediately  detected. 

The  examination  of  demand  loans  and  collaterals  therewith 
is  one  of  the  most  important  branches  of  the  work.  Exten- 
sive defalcations  have  been  covered  up  by  the  failure  to  en- 
dorse partial  payments  on  the  notes ;  the  only  way  to  ascertain 
the  correctness  of  these  loans  and  collaterals  is  to  send  out  a 
memorandum  to  each  borrower,  setting  forth  the  amount  of 
loans  and  collaterals  held  as  at  the  day  of  commencing  the 


BANKS.  117 

audit.    The  confirmation  should,  of  course,  be  returned  direct 
to  the  auditor. 

The  recent  death  of  a  prominent  broker  in  Philadelphia  dis- 
closed the  fact  that  for  some  years  he  had  been  borrowing 
large  sums,  aggregating  nearly  one  million  dollars,  from  banks 
upon  stock  certificates  which  had  been  "  raised ''  from  a  small 
to  a  much  larger  number  of  shares.  The  forgeries  were  clev- 
erly executed,  and  in  every  case  deceived  bank  officers  through 
whose  hands  they  passed,  so  that  a  professional  auditor  could 
hardly  be  criticised  for  failure  to  detect  the  alterations;  the 
instance  should,  however,  be  borne  in  mind,  and  a  knowledge 
of  the  facts  in  this  case  may  be  a  reminder  to  an  auditor  that 
"  eternal  vigilance  "  is  always  necessary  in  bank  audits. 

In  connection  with  the  inspection  of  securities,  it  is,  per- 
haps, well  to  call  attention  to  the  extreme  importance  of  all 
the  securities  being  produced  simultaneously,  and  of  their 
all  remaining  in  the  auditor's  sole  keeping  until  the  inspection 
is  completed.  Extensive  frauds  have  been  known  to  remain 
undetected  through  failure  to  observe  this  simple  precaution. 
If  the  examination  cannot  be  completed  the  first  day,  the 
securities  and  bills  not  inspected  should  be  locked  up,  and 
access  denied  to  any  one  connected  with  the  bank  except  under 
the  eye  of  the  auditor. 

The  accounts  with  other  banks  will  have  to  be  verified  by 
correspondence,  and  these  confirmations  should  also  be  directed 
to  the  auditor  and  not  to  the  bank. 

How  far  the  auditor  should  extend  his  examination  of  the 
depositors'  accounts  is  a  matter  concerning  which  considerable 
diflference  of  opinion  obtains.  The  ideal  way  would  be  to 
have  all  the  pass-books  called  in  at  once,  and  have  them  settled 
by  the  auditor's  own  staff.  It  is,  of  course,  practically  impos- 
sible to  do  this,  but  it  is  of  the  utmost  importance  that  as  many 
be  examined  as  possible.  The  auditor  should  keep  a  list  of  the 
books  inspected,  and  in  the  course  of  a  few  years  the  entire 
list  of  customers  might  be  covered. 


^     OF  THE 

UNIVERSITY 

OF 


Il8  AUDITING. 

The  auditor  should  see  that  a  proper  internal  system  of 
checking  the  balances  prevails.  It  is  now  customary  in  large 
banks  for  all  pass-book  balances  to  be  compared  with  the 
ledgers  and  initialed  by  some  one  other  than  the  bookkeeper 
before  they  are  handed  to  the  customer,  and  in  some  banks 
customers  are  requested  to  fill  out  and  return  a  memorandum 
confirming  the  balance. 

A  number  of  banks,  more  particularly  in  the  West,  have 
adopted  a  system  of  stating  depositors'  accounts  which  is  su- 
perior to  the  pass-book  settlement.  Their  practice  is  to  pre- 
pare monthly  statements  of  all  accounts;  these  are  mailed  to 
the  depositors  with  the  paid  cheques  or  vouchers.  This  plan 
has  the  merit  of  enabling  the  auditor  to  verify  all  the  deposit- 
ors' balances  at  the  same  date,  as  he  can  compare  the  state- 
ments therewith,  enclose  a  request  for  confirmation  of  their 
correctness  and  mail  them  himself,  thus  insuring  the  best  check 
which  it  seems  possible  to  devise. 

It  will  be  observed  that  the  view  adopted  here  with  regard 
to  a  bank  audit  is  that  the  verification  of  certain  details  may, 
and  indeed  must,  to  a  large  extent  be  left  to  the  staff  audit. 
The  recent  frauds  upon  the  Bank  of  Liverpool,  which  paid 
upwards  of  $850,000  upon  cheques  forged  by  one  of  its  ledger 
clerks,  may  perhaps  raise  a  question  as  to  whether  this  reli- 
ance upon  the  system  of  internal  check  is  altogether  justified 
in  practice.  It  is  thought,  however,  that  the  Liverpool  frauds 
have  little,  if  any,  bearing  upon  the  point,  in  that  the  system 
of  internal  check  seems  to  have  been  chiefly  conspicuous  by  its 
absence,  or  at  least  by  its  inefficiency.  Three  of  the  funda- 
mental rules  of  any  effective  system  are:  (a)  That  no  clerk 
should  have  access  to  books  recording  entries  which  go  to 
check  the  entries  kept  by  that  clerk,  e.  g.,  tellers  should  not  be 
permitted  to  keep  or  assist  in  keeping  any  of  the  ledgers  or 
taking  off  trial  balances  thereof,  (b)  That  the  clerks  should 
be  shifted  about  at  frequent  intervals,  so  that  a  fraud — even 
if  committed — may  be  speedily  detected  by  a  fresh  clerk  go- 
ing over  the  same  ground,     (c)  That  no  unusual  entries,  as. 


BANKS.    .  119 

for  example,  transfers,  should  ever  be  made  without  special 
authority.  None  of  these  rudimentary  precautions  appear  to 
have  been  adopted  in  the  case  mentioned,  and  it  seems  safe 
to  say  that,  had  any  one  of  them  been  in  force,  the  frauds 
could  not  have  been  committed,  or  would  at  least  have  been 
discove,red  at  a  very  early  date.  At  the  same  time,  as  has 
already  been  stated  elsewhere,  it  is  always  desirable  that  an 
auditor,  when  considering  the  exact  extent  of  his  investiga- 
tion, should  make  careful  inquiry  into  the  system  of  internal 
check  employed,  and  satisfy  himself  that  the  system  theoret- 
ically in  force  is  actually  carried  out  in  practice. 

In  dealing  with  bank  accounts,  and  all  other  accounts  of  a 
similar  nature,  the  auditor  must  never  forget  that  his  responsi- 
bilities are  not  confined  to  safeguarding  the  interests  of  the 
proprietors.  His  certificate  is  virtually — whatever  it  may  be 
legally — a  guarantee  to  the  public  that  the  accounts  submitted 
are  to  be  relied  upon  as  being,  in  every  respect,  correct.  It 
is  not,  of  course,  suggested  that  he  guarantees  the  safety  of 
the  customers'  deposits;  but  he  would  reasonably  be  blamed 
were  it  to  transpire  that  a  bank  which  he  had  certified  as  sol- 
vent was  afterwards  discovered  to  have  been  hopelessly  in- 
solvent at  the  time  of  such  certification. 

At  first  sight  it  may  appear  impossible  for  the  auditor  to  act 
up  to  the  position  here  indicated,  but  he  must  remember  that, 
in  reality,  the  test  of  an  auditor's  competency  is  in  his  ability 
to  judge  of  the  correctness  of  items  by  an  exhaustive  testing — • 
not  necessarily  of  the  items  themselves,  but  of  their  totals. 

A  few  remarks  concerning  the  revenue  account  will  not  be 
out  of  place.  The  items  of  interest  constituting  the  gross 
profit  must  be  carefully  tested,  especially  as  to  the  rate  charged 
upon  current  transactions,  and  the  interest  and  dividends  upon 
securities  owned  must,  of  course,  all  be  accounted  for. 

It  will  frequently  be  found  that  the  banking  house  and  fix- 
tures are  carried  at  a  sum  considerably  less  than  their  value, 
and  this  constitutes  one  of  the  secret  reserves  that  many  con- 


120  AUDITING. 

servative  bankers  favor.  The  most  recent  instance  is  that  of 
a  prominent  trust  company  in  Philadelphia,  which  has  erected 
a  magnificent  banking  house  (costing  about  $1,500,000) 
charging  the  cost  thereof  against  current  earnings  during  the 
three  years  in  which  it  was  being  built,  so  that  the  property 
account  represents  the  cost  of  the  land  only.  It  should  be  stated, 
however,  that  in  this  case  the  stockholders  were  notified  of  the 
intention  to  so  treat  the  account.  While  frankly  admitting 
that  the  abuse  of  secret  reserves  is  to  be  deprecated,  it  must 
be  remembered  that  a  balance  sheet  is  not — and  does  not  pur- 
port to  be — ^a  statement  of  finally  determined  facts,  but  rather 
an  estimate  of  a  position  of  affairs  which  by  its  very  nature 
cannot  be  accurately  determined.  As  proof  of  this  it  may 
be  mentioned  that  only  a  few  banks  in  the  United  States  carry 
any  reserve  for  unearned  discounts,  yet  in  a  large  bank  this 
is  a  very  considerable  item. 

The  time  will  probably  come  when  all  banks  will  be  required 
to  keep  their  accounts  upon  a  more  scientific  basis,  and  the 
bank  officer,  who  now  freely  criticises  a  customer's  statement 
which  takes  credit  for  future  earnings,  will  reach  the  point 
where  his  own  statement  will  reflect  conditions  more  in  accord 
with  the  facts  than  is  now  the  case. 

The  audit  of  Savings  Banks  will  be,  in  the  main,  along  prac- 
tically the  same  lines  as  that  of  national  or  State  banks, 
though  naturally  it  will  be  found  that  the  assets  consist  more 
of  long-term  investments,  such  as  bonds,  than  of  loans.  Com- 
mercial paper  or  unsecured  loans  should  not  be  found  at  all. 

It  will  probably  be  found  more  practicable  to  verify  the 
depositors'  balances  by  sending  out  statements  thereof,  with 
provision  for  confirmation  and  return  direct  to  the  auditor  at 
a  special  post-office  box  than  by  calling  in  pass-books. 

In  the  foregoing  remarks  the  desirable  extent  of  the  audi- 
tor's duties  has  been  stated  rather  than  the  bare  limits  of  his 
legal   responsibilities;   the  latter   question   will,   however,   be 


INSURANCE   COMPANIES.  121 

found  more  fully  discussed  under  the  heading  of  "  The  Lia- 
bilities of  Auditors." 

(b)  TRUST  COMPANIES.— During  the  past  twenty-five 
years  trust  companies  have  increased  greatly,  both  in  numbei- 
and  importance,  in  the  United  States.  In  addition  to  acting 
in  a  fiduciary  capacity  and  exercising  trust  functions,  they  are 
authorized  in  many  states  to  transact  a  banking  business.  Their 
charters  are  usually  more  liberal  than  those  of  either  national 
or  state  banks;  even  as  to  banking  functions  themselves  they 
enjoy  certain  advantages  over  banks,  being  permitted,  for  ex- 
ample, to  make  loans  on  real  estate,  which  national  banks  are 
not,  though  on  the  other  hand  they  are  not  permitted  to  issue 
circulating  notes  and  they  are  forbidden  in  some  states  to 
discount  commercial  paper.  In  at  least  one  state,  Illinois, 
banks  are  permitted  on  due  compliance  with  provisions  of  the 
law,  to  conduct  a  trust  department. 

It  follows  that  the  audit  of  a  trust  company  partakes  in  a 
large  measure  of  the  nature  of  a  bank  audit  which  has  al- 
ready been  referred  to  under  (a).  To  be  thorough,  however, 
the  audit  must  not  be  limited  to  the  banking  department  but 
embrace  the  trust,  safe  deposit  and  such  other  departments  as 
may  be  conducted  by  the  company  under  examination.  The 
examination  of  the  securities  in  the  trust  department,  for  in- 
stance, is  just  as  important  as  the  audit  of  the  banking 
department. 

The  audit  of  the  income  and  expenses  of  the  various  de- 
partments must  likewise  not  be  overlooked,  though  the  exact 
procedure  will  be  more  or  less  dependent  on  the  circumstances 
connected  with  each  individual  case  and  to  a  considerable  ex- 
tent on  the  system  of  internal  check.  The  volume  of  routine 
detail  in  a  large  trust  company  is  very  great,  but  if  a  proper 
system  is  in  use  the  examination  of  much  of  it  may  safely  be 
omitted. 

(c)  INSURANCE  COMPANIES.— The  general  corpora- 
tion laws  of  the  various  states  do  not,  usually,  cover  insur- 


122  AUDITING. 

ance  companies,  and  they  must  incorporate  under  special  laws. 
These  laws  give  the  companies  special  privileges,  but  they 
also  impose  numerous  restrictions.  In  most  of  the  states 
there  is  an  Insurance  Department  which  is  empowered  to  ex- 
amine the  affairs  of  all  companies,  local  and  foreign,  doing 
business  within  the  state.  These  departments  vary  consider- 
ably as  to  methods,  and  while  the  examinations  made  by  some 
of  them  are  thorough  in  their  nature,  yet  their  purpose  is 
not  in  line  with  that  of  an  audit  conducted  in  the  interests 
of  stockholders.  Like  the  examinations  of  national  banks, 
these  audits  are  not  to  be  relied  upon  to  prevent  fraud  or  care- 
lessness by  the  employees,  because  the  chief  object  of  the 
state  examination  is  merely  to  determine  the  solvency  of  the 
company,  and  its  observance  of  the  state  laws. 

A  number  of  the  European  companies  have  their  American 
accounts  audited  and  reported  upon  monthly,  and  this  may 
form  a  valuable  part  of  an  auditor's  practice.  These  monthly 
examinations  are  of  the  nature  of  a  continuous  audit,  and 
should,  of  course,  be  supplemented  by  a  more  exhaustive  audit 
at  the  end  of  the  year. 

The  accounts  of  a  FIRE  INSURANCE  COMPANY  are 
usually  not  at  all  complicated,  and  it  will  be  in  order  to  outline 
briefly  the  more  important  parts  of  an  auditor's  work  in  con- 
nection therewith. 

The  income  must  be  thoroughly  checked.  The  agents'  orig- 
inal reports  form  the  basis  of  the  premium  income,  and  enough 
of  them  should  be  checked  into  the  books  to  test  their 
accuracy. 

The  remittances  from  agents  should  be  properly  recorded 
at  once,  and  no  opportunity  afforded  to  the  cashier  to  "  hold 
over  "  remittances. 

The  total  outstandings  due  from  agents  at  the  end  of  the 
period  should  be  thoroughly  verified.  The  detailed  balances 
should  be  analyzed,  and  any  accounts  in  arrears  should  be 


INSURANCE   COMPANIES.  123 

taken  up  with  the  manager.  It  should  be  an  invariable  rule  to 
have  some  one  other  than  the  cashier  write  the  agents  about 
their  overdue  accounts. 

A  considerable  part  of  the  income  arises  from  investments; 
this  can  be  checked  thoroughly,  and  must  not  be  overlooked. 

Likewise  the  examination  of  the  securities  themselves  forms 
an  important  part  of  the  audit,  and  will  be  conducted  on  the 
same  lines  as  with  banks. 

The  vouching  of  the  cash  payments  very  often  occupies  a 
larger  proportion  of  the  time  than  should  be  given  to  it;  of 
course,  the  work  is  important,  but  it  may  be  noted  that  an 
analysis  of  defalcations  in  insurance  offices  discloses  the  fact 
that  very  few  are  in  connection  with  fraudulent  vouchers.  It 
is  perhaps  enough  to  say  that  the  loss,  expense  and  all  other 
vouchers  should  be  properly  approved  and  recorded,  and  if 
this  is  seen  to,  the  payments  will  have  been  sufficiently  covered. 
In  connection  with  the  payments  there  should  be  in  force  a 
good  system  of  recording  re-insurances,  so  that  in  case  of  a 
loss  the  re-insured  portion  will  surely  be  collected. 

The  verification  of  allowances  to  agents  for  rebates,  return 
premiums  and  commissions  falls  under  the  heading  of  vouch- 
ers. Some  special  knowledge  is  desirable  in  this  connection, 
but  with  reasonable  care  these  points  can  be  satisfactorily 
covered. 

The  balance  sheet  items  require  very  little  explanation,  and 
present  no  unusual  features,  with  one  or  two  exceptions.  In 
most  States  the  insurance  departments  will  not  permit  furni- 
ture and  fixtures  to  appear  as  assets  in  the  company's  reports, 
and  for  this  reason  very  few  companies  carry  this  account. 
This  is  an  instance  of  a  secret  reserve,  although  not  very 
flagrant. 

The  principal  item  among  the  liabilities  is  that  of  unearned 
premiums,  or,  as  it  is  usually  termed,  the  Re-insurance  Re- 


124  AUDITING. 

serve.  This  must  be  calculated  on  the  basis  prescribed  by 
statute  or  by  the  regulations  of  the  insurance  department. 
The  basis  most  generally  used  is  that  of  reserving  50  per  cent, 
of  the  gross  premiums  (less  re-insurance)  on  all  unexpired 
fire  risks  running  one  year  or  less  from  date  of  policy,  includ- 
ing interest  premiums  on  perpetual  fire  risks,  and  pro  rata 
percentages  of  the  gross  premiums  on  unexpired  risks  run- 
ning more  than  one  year  from  the  date  of  the  policy ;  the  liabil- 
ity on  perpetual  policies  is  taken  in  at  the  amount  of  the 
deposit  reclaimable  by  the  insured. 

Ample  provision  should  also  be  made  for  losses  adjusted  and 
unpaid,  and  for  all  other  losses  which  may  be  disputed  or 
unadjusted,  as  well  as  for  accrued  taxes,  unpaid  expenses,  &c. 

A  very  good  article  on  auditing  insurance  accounts,  by 
George  Wilkinson,  C.P.A.,  appeared  in  The  Business  World  for 
August  and  October,  1904,  and  will  well  repay  reading. 

The  audit  of  a  LIFE  INSURANCE  COMPANY  will  pre- 
sent very  few  unusual  points.  The  distinguishing  feature  of 
these  accounts  is  the  actuarial  valuation  of  the  Company's  lia- 
bility to  the  policy  holders.  The  auditor  is  not  responsible 
for  the  accuracy  of  this  valuation,  but  it  is  his  duty  to  see 
that  the  accounts  are  duly  prepared  in  accordance  with  the 
actuary's  figures. 

On  account  of  the  nature  of  the  business  the  investments 
will  be  a  very  considerable  item,  and  will  be  likely  to  include 
more  real  estate  and  other  fixed  property  than  is  usually 
owned  by  any  other  undertaking.  In  most  of  the  States  the 
companies  cannot  purchase  real  estate  except  for  their  own 
occupancy,  but  as  this  has  been  construed  to  cover  enormous 
office  buildings,  from  which  large  rentals  are  received,  and 
as  foreclosure  proceedings  bring  in  numerous  other  parcels, 
it  usually  happens  that  a  very  fair  portion  of  the  assets  will 
be  represented  by  real  estate.  The  income  from  rentals,  &c., 
will  have  to  be  looked  after  carefully  and  the  balance  sheet 


INSURANCE    COMPANIES.  125 

valuations  should  be  supported  by  the  appraisals  of  competent 
men. 

The  loans  made  by  the  company  to  its  policy  holders  upon 
the  assignment  of  their  poHcies  as  collateral  should  be  care- 
fully checked,  and  the  presence  in  each  case  of  the  policy 
properly  assigned  ascertained.  These  loans  are  supposed  to 
constitute  one  of  the  best  assets  which  life  insurance  companies 
possess. 

As  a  rule,  investments  must  be  made  in  accordance  with 
State  laws,  but  an  auditor  can  hardly  do  more  than  obtain  a 
certificate  from  the  company's  counsel  that  the  laws  have  been 
properly  complied  with.  The  valuation  of  the  investments  is 
also  a  most  important  matter;  this  is  considered  in  Chapter 
VII  hereof. 

Insurance  companies  as  a  rule  do  not  carry  any  liabilities 
on  their  books  for  accrued  expenses,  with  the  exception  in 
some  cases  of  an  allowance  for  medical  fees,  because  it  is  their 
custom  to  charge  these  expenses  only  as  paid.  Recently,  how- 
ever, the  State  examiners  have  recommended  that  proper  re- 
serves be  carried  for  accrued  salaries,  rents,  office  expenses, 
taxes,  bonuses,  commissions,  legal  fees,  &c.  The  plan  is,  of 
course,  in  the  line  of  proper  accounting. 

The  routine  of  the  audit  will  differ  but  little  from  that  of 
fire  companies  but  the  auditor  will  be  wise  to  pay  particular 
attention  to  the  surrenders.  Claims  should  also  be  more  care- 
fully looked  at  than  is  necessary  in  fire  offices. 

The  audit  of  the  investments  will  be  a  much  more  volumi- 
nous matter  than  before,  and  will  require  considerable  care, 
both  to  see  that  the  principal  is  intact  and  that  the  prescribed 
income  has  been  received.  As,  however,  the  method  of  keep- 
ing investment  ledgers  varies  very  considerably  with  different 
offices,  this  matter  cannot  well  be  gone  into  in  further  detail. 

ACCIDENT,  TITLE  GUARANTEE,  GENERAL  AND 
SPECIAL  LIABILITY  AND  OTHER  COMPANIES  do 


126  AUDITING. 

not  raise  any  new  considerations.  The  great  majority  of  such 
accounts  follow  entirely  upon  the  lines  of  fire  companies,  the 
principal  variation  being  that  the  basis  of  calculating  the  un- 
earned premiums  or  re-insurance  reserve  differs  in  some  cases, 
e.  g.,  in  the  case  of  marine  and  inland  navigation  companies  it 
is  usual  to  set  up  as  such  reserve  the  entire  amount  of  the 
gross  premiums  on  unexpired  risks.  The  business  of  health 
insurance,  however,  more  nearly  approaches  that  of  life  insur- 
ance, and  actuarial  assistance  will  be  required  for  the  deter- 
mination of  the  value  of  the  unexpired  risks. 

{d)  INVESTMENT  COMPANIES.— The  accounts  of 
these  companies  are  probably  as  simple  as  accounts  can  well 
be.  The  ostensible  purpose  of  such  companies  is  to  enable  in- 
vestors to  spread  their  capital  over  a  large  field,  and  so,  by 
the  principle  of  average,  obtain  a  better  security  for  their 
principal  without  a  corresponding  sacrifice  of  interest. 

The  history  of  many  of  our  mortgage  and  debenture  com- 
panies has  not  been  satisfactory  from  the  investors'  point  of 
view,  and  an  auditor's  position  here  is  a  responsible  one. 

The  auditor  will  require  to  see  the  original  memoranda 
for  all  sales  and  purchases,  and  also  to  ascertain  that  all  in- 
terest and  dividends  have  been  properly  accounted  for.  Pur- 
chases cum  div.  and  sales  ex  div.  will  probably  be  the  most 
likely  cases  in  which  an  irregularity  may  occur.  Only  income 
earned  during  the  time  that  an  investment  is  held  should  be 
credited  to  revenue,  while  per  contra  revenue  is  entitled  to 
take  credit  for  all  the  income  earned  during  that  period. 

The  valuation  of  investments  is  perhaps  the  most  important 
function  of  the  audit  of  investment  companies.  Under  exist- 
ing conditions,  the  auditor  cannot,  of  course,  prevent  the  direc- 
tors issuing  accounts  stating  investments  at  cost  price  (regard- 
less of  value)  but  he  at  least  can — and  certainly  should — call 
attention  in  his  report  to  anything  that  he  considers  to  be  an 
undue  inflation  of  assets. 


INVESTMENT   COMPANIES.  \2'J 

It  is  not  always  imperative  that  investments  should  be 
written  down  to  market  price.  In  the  first  place,  the  principle 
of  averages  may  consistently  be  followed  here,  and  it  will 
suffice  if  the  total  market  price  be  not  less  than  the  total  cost 
price.  If,  however,  there  be  a  deficiency  in  this  respect,  it 
should  be  met,  not  by  a  revision  of  individual  values,  but  by  a 
setting  aside  of  a  lump  sum  to  an  Investment  Fluctuation  Ac- 
count as  a  reserve  against  loss.  This  reserve  may  either  be 
deducted  from  the  amount  of  investments  in  the  balance  sheet, 
or  separately  stated  as  a  liability.  A  reserve  so  created 
should,  except  in  very  special  cases,  not  be  reduced  in  subse- 
quent years,  except  for  the  purpose  of  providing  for  the  actual 
loss  realized  upon  the  sale  of  depreciated  investments. 

When  the  total  market  value  exceeds  the  total  cost  price 
it  is  not  at  all  desirable  that  the  capital  value  of  the  investments 
be  increased.  To  credit  such  an  increase  to  revenue  is  dearly 
as  incorrect  as  it  would  be  to  credit  it  with  an  assumed  increase 
in  the  value  of  goodwill.  There  is  no  particular  harm  in  writ- 
ing up  the  assets  and  crediting  the  difference  to  a  reserve  not 
available  for  equalizing  dividends,  but  it  is  much  better  kept  in 
hand — at  all  events  until  the  permanence  of  the  increase  be  well 
assured — as  a  secret  reserve,  against  which  the  company  may 
draw  in  bad  times. 

With  regard  to  the  profits  or  losses  arising  from  sales  made 
during  the  period  under  audit,  in  the  first  place  the  dividend 
should  be  apportioned  (from  day  to  day)  so  that  the  actual 
capital  profit  or  loss  may  be  arrived  at.  Such  profits  and 
losses  made  during  any  one  3'ear  should  be  treated  in  the 
aggregate ;  if  the  result  be  a  profit,  it  is  available  for  dividend ; 
if  a  loss  be  the  result,  it  should  come  out  of  revenue,  unless 
an  adequate  reserve  exists  from  which  the  loss  may  be  taken. 
It  is,  however,  highly  desirable  that  profits  made  by  changes 
of  investments  be  taken  to  reserve,  and  not  credited  to  revenue. 
Although  if  the  directors  of  the  company  choose  to  pursue  the 
opposite  course  they  would  doubtless  be  wholly  within  their 


128  AUDITING. 

legal  rights  and  the  auditor  could  not  do  much  more  than  to 
see  that  the  profits  on  changes  of  investments  are  not  reported 
as  current  income. 

In  bad  times  the  conscientious  auditor  of  investment  com- 
panies has  an  unthankful  task  before  him,  but  he  must  not 
shrink  from  the  responsibilities  of  his  situation. 

It  is  important  to  distinguish  between  investment  companies 
and  speculative  finance  companies.  The  chief  profits  of  the 
former  are  income  derived  from  investments,  and  profits  de- 
rived from  a  change  of  investments  only  arise  incidentally. 
In  connection  with  the  latter  the  profits  derived  from  a  change 
of  investments  form  the  main  source  of  income ;  consequently 
all  such  investments  must  be  regarded  as  so  much  stock-in- 
trade — as  current  assets — and  valued  accordingly,  whereas  the 
investments  of  a  bona  fide  investment  company  may  fairly 
be  treated  as  fixed  assets.  The  importance  of  this  distinction 
lies  in  the  fact  that  whereas  the  investments  of  a  speculative 
finance  company  ought  never  to  be  valued  at  a  price  in  excess 
of  the  current  market  price,  it  is  frequently  difficult  (if  not  im- 
possible) to  arrive  at  any  reliable  basis  of  valuation;  for  stock 
exchange  quotations  are  by  no  means  necessarily  a  reliable 
basis,  if  there  be  no  free  market.  Again,  it  may  be  pointed 
out  that,  following  the  ordinary  principles  of  the  valuation 
of  unsold  stock,  no  appreciation  in  the  value  of  investments 
ought  to  be  credited  to  revenue  until  those  investments 
have  been  actually  sold.  It  is  not,  however,  necessary  to 
write  down  each  separate  investment  that  has  depreciated, 
while  writing  up  those  that  have  appreciated ;  the  proper  course 
would  appear  to  be  to  maintain  the  investments  in  the  balance 
sheet  at  cost  price,  making  provision  for  a  reserve  sufficient  to 
cover  any  deficiency  in  the  aggregate  intrinsic  value,  as  con- 
trasted with  the  aggregate  book  value.  Realized  profits  may, 
of  course,  be  properly  credited  to  revenue ;  but  care  should  be 
taken  to  see  that  they  have  been  actually  realized  in  cash,  and, 
so  far  as  possible,  the  auditor  should  be  upon  his  guard  against 


STOCKBROKERS.  1 29 

the  inflation  of  profits  by  means  of  "  accommodation  "  trans- 
actions between  different  members  of  a  group  of  companies. 
Probably  the  Whitaker  Wright  frauds  will  be  sufficiently  fresh 
in  the  minds  of  readers  to  make  unnecessary  any  detailed 
explanation  of  what  is  alluded  to  under  this  heading. 

This  whole  point  was  very  carefully  covered  and  clearly 
stated  in  Mr.  Dickinson's  paper,  "  Profits  of  a  Corporation," 
already  referred  to.  The  section  is  reproduced  in  full,  page 
224  hereof. 

To  sum  up,  it  appears  that  although,  so  far  as  the  authorities 
have  hitherto  gone,  it  would  appear  that  under  some  cir- 
cumstances dividends  may  be  legally  declared  out  of  current 
revenue  without  first  making  good  depreciation  of  invest- 
ments, it  is,  on  the  other  hand,  certain  that  the  declaration 
of  such  dividends  is  a  direct  violation  of  every  principle  of 
sound  finance,  and  should  at  all  times  be  discouraged  by  the 
auditor  who  should  make  sure  that  the  true  position  of  affairs 
is  sufficiently  revealed  to  the  stockholders  either  upon  the  face 
of  the  accounts  or  by  a  special  clause  included  in  his  report. 

(e)  STOCKBROKERS.— A  considerable  amount  of  mys- 
tery appears  to  envelop  stock  exchange  accounts,  and  the 
remark  has  frequently  been  made  that  the  audit  of  brokers' 
accounts  is  altogether  too  technical  a  matter  to  be  safely  con- 
ducted by  the  general  practitioner.  The  advantage  of  special 
practical  knowledge  on  the  part  of  the  auditor  has  already  been 
freely  admitted  by  the  authors,  but  it  is  contended  that  the  de- 
sirable knowledge  may  be  readily  obtained,  even  by  the  general 
practitioner ;  and,  with  stock  exchange  accounts  in  particular,  it 
is  suggested  that  the  necessity  of  ''  specialism  "  has  been  greatly 
exaggerated. 

It  is,  however,  essential  that  an  auditor  should  have  had 
some  acquaintance  with  brokers'  books  before  attempting  an 
audit,  and  this  can  frequently  be  gained  by  the  special  work 
which  they  require  at  especially  busy  periods. 


130  AUDITING. 

Brokers'  books  differ  widely  from  the  usual  books  of  ac- 
count. Many  use  a  cash  journal  which  serves  as  a  daily 
record  of  all  cash  and  securities  received  and  delivered.  In 
this  book  the  left-hand  page  contains  the  receipt  of  cash  and 
the  delivery  of  securities,  while  the  right-hand  page  represents 
cash  payments  and  receipts  of  securities,  or  vice  versa. 

The  subsidiary  books  also  vary  materially  from  commercial 
books,  and  some  little  experience  is  valuable,  and  perhaps 
essential,  before  attempting  to  audit  them. 

In  the  large  New  York  houses  initials  are  used  for  all 
active  stocks,  which  is  not  only  confusing,  but  requires  consid- 
erable memorizing  before  any  attempt  can  be  made  to  verify 
the  books. 

As  in  a  bank,  a  large  force  must  be  put  on  without  notice, 
and,  as  the  stocks  will  have  to  be  "  balanced  "  before  many 
changes  occur,  this  will  mean  quick  and  accurate  work. 

For  the  benefit  of  those  not  familiar  with  stock  exchange 
transactions,  it  may  be  said  that  all  big  brokerage  houses  carry 
large  lines  of  stocks  and  bonds  for  customers  ''  on  margin." 
These  are  in  turn  hypothecated  with  their  banks  as  collaterals 
for  loans.  It  is  necessary,  therefore,  to  go  through  the  cus- 
tomers' ledgers  and  prepare  a  list  of  all  stocks  and  bonds  to  be 
accounted  for,  taking  into  account  the  "  shorts  "  as  well  as 
"  longs."  Lists  must  then  be  prepared  of  the  stocks  and  bonds 
deposited  with  the  banks,  and  the  securities  verified  by  corre- 
spondence, those  on  hand  in  the  "  box  "  must  be  examined,  and 
the  stocks  at  transfer  offices  checked.  If  everything  is  in 
order  the  lists  will  balance. 

In  an  active  market  all  this  must  be  done  within  a  very 
few  hours  or  the  verification  will  be  worthless,  as  the  changes 
will  be  too  numerous  to  follow. 

Customers'  accounts  at  the  first  end  of  the  month  after  the 
audit  commences  should  be  mailed  by  the  auditor,  and  the 
confirmations,  which  are  usually  addressed  to  the  client,  should 
be  secured  before  being  opened  by  the  clerks. 


STOCKBRBOKERS.  I3I 

llie  custom  of  having  the  confirmations  mailed  direct  to  the 
auditor  has  made  satisfactory  headway  during  the  last  few 
years. 

Testing  the  charges  for  interest  and  commissions  may  dis- 
close a  fruitful  source  of  errors,  as  it  is  not  unusual  to  discover 
inaccuracies  v/hich  will  repay  the  cost  of  the  audit.  These  can 
readily  happen  on  busy  days,  as  it  is  not  possible  to  prove  the 
calculations  except  by  going  back  over  them,  and  this  is  not 
always  done. 

For  the  audit  of  these  accounts  to  be  of  any  value,  how- 
ever, it  is  necessary  that  it  should  be  of  the  most  detailed 
description;  the  danger  of  error  or  fraud — either  of  which 
might  assume  alarming  proportions — is  extremely  great,  and 
the  utmost  care  and  circumspection  are,  therefore,  imperative. 

Perhaps  the  chief  danger  in  this  class  of  audits  lies  in  the 
fact  that  in  the  great  majority  of  offices  there  exists  no  regular 
system  affording  a  reliable  internal  check,  and  no  efficient 
supervision.  To  remedy  this  obvious  weakness  the  visits  of 
the  auditor  should  be  frequent,  say,  at  least  twice  during  each 
year ;  indeed — although  a  "  completed  "  audit  is  doubtless  use- 
ful, as  affording  a  reliable  periodical  statement  of  accounts — 
the  only  really  efficient  audit  of  stock  brokers'  accounts  would 
appear  to  be  one  that  is  both  detailed  and  continuous. 


CHAPTER  IV. 


SPECIAL    CONSIDERATIONS 
IN    DIFFERENT    CLASSES    OF    AUDITS. 


(Continued.) 


IV.      PUBLIC    SERVICE    CORPORATIONS. 

The  recent  agitation  in  the  United  States  with  regard  to 
municipal  ownership  of  public  utilities  has  aroused  consider- 
able interest  in  the  methods  of  keeping  the  accounts  of  such 
utilties  and  preparing  them  for  publication.  So  far  municipal 
operation  has  not  proved  so  successful  as  municipal  ownership 
coupled  with  private  operation  through  leases,  and  it  is  prob- 
able that  the  latter  plan  will  prove  more  desirable  for  some 
time  to  come.  Furthermore,  the  great  majority  of  public  utili- 
ties in  this  country  are  still  being  operated  under  franchises, 
many  of  them  perpetual  or  practically  so,  granted  to  private 
corporations. 

The  day  may  come,  however,  when  all  public  service  cor- 
porations, at  least  in  the  more  populous  States,  will  be  under 
the  supervision  of  a  State  Board,  or  Commission,  empowered 
to  fix  rates  and  compel  reports  prepared  along  uniform  lines. 
The  State  of  New  York  enacted  laws  in  1907  creating  two 
Public  Service  Commissions  (one  for  the  counties  of  New 
York,  Kings,  Queens  and  Richmond,  and  the  other  for  the  re- 
maining counties  of  the  State)  which  in  addition  to  other  broad 
powers  were  vested  with  the  power  to  prescribe  uniform  sys- 

132 


PUBLIC  SERVICE  CORPORATIONS.  I33 

terns  of  accounts  for  the  electric  railways,  gas  companies  and 
electric  light,  heat  and  power  companies  operating  in  the  State. 
This  power  has  been  exercised,  classifications  of  accounts  for 
the  three  classes  of  corporations  mentioned  having  been  pro- 
mulgated by  the  Commissions. 

The  most  notable  case  of  public  regulation  is  that  of  the 
Interstate  Commerce  Commission,  appointed  under  authority 
of  Congress  to  supervise  the  operation  of  steam  railways  doing 
an  interstate  business.  The  results — so  far  as  encouraging, 
and  in  some  cases  compelling,  the  keeping  of  and  submitting 
accounts  prepared  along  uniform  lines — have  been  wonderfully 
successful,  and  part  of  the  prosperity  of  our  railways  is  no 
doubt  attributable  to  the  increased  attention  which  has  neces- 
sarily been  given  to  the  accounting  departments  of  the  railway 
corporations  which  have  been  subject  to  this  control. 

By  amendments  made  to  the  Interstate  Commerce  Act  in 
1906,  the  powers  of  the  Commission  were  very  much  broad- 
ened, its  jurisdiction  being  extended  to  cover  electric  railways, 
express  companies,  sleeping-car  companies,  carriers  by  water 
(as  described  in  the  act)  and  pipe  lines  (excepting  water  and 
gas)  transacting  an  interstate  business.  In  addition  to  other 
far-reaching  powers,  including  the  fixing  of  maximum  rates, 
the  Commission  is  now  empowered,  not  only  to  call  for  uni- 
form reports,  but  also  to  prescribe  a  uniform  system  of  ac- 
counts for  each  of  the  transportation  agencies  named,  deviation 
from  which  becomes  a  penal  offense.  It  is  of  particular  inter- 
est to  accountants  that  the  classification  of  accounts  for  steam 
railroads  promulgated  by  the  Commission  requires  that  entries 
for  depreciation  of  equipment  be  made  and  it  is  to  be  expected 
that  in  due  season  such  depreciation  charges  will  require  to  be 
made  for  other  parts  of  the  physical  property  in  which  depre- 
ciation undoubtedly  occurs.  This  official  recognition  by  an 
important  governmental  body  of  a  principle  for  which  account- 
ants have  long  contended  is  a  "  sign  of  the  times  "  and  should 
assist  in  convincing  our  courts  when  the  question  of  deprecia- 


134  AUDITING. 

tion  comes  up  for  judicial  determination  that  it  cannot  be  con- 
sidered otherwise  than  as  a  charge  to  be  reckoned  with  and 
provided  for  before  stating  net  profits  or  paying  dividends. 

In  the  case  of  local  public  service  corporations,  State  Legis- 
latures can  readily  and  in  some  cases  have,  passed  the  necessary 
acts  delegating  to  commissions  or  municipalities  the  power  to 
fix  rates. 

This  puts  a  responsibility  on  an  auditor  which  is  far  more 
serious  than  when  he  is  deaHng  solely  with  stockholders  and 
other  owners,  for  now  he  finds  himself  not  only  in  the  position 
of  safeguarding  the  interests  of  the  owners,  but  he  also  occu- 
pies a  quasi-public  position.  The  accounts  to  which  he  certifies 
should  not  be  so  conservative  that  the  profits  are  unduly  dimin- 
ished and  the  public  deceived ;  nor,  on  the  other  hand,  should 
they  be  so  lacking  in  proper  reserves  and  depreciation  allow- 
ances that  the  profits  will  appear  too  large,  and  the  attention  of 
the  consumers  will  consequently  be  called  to  this  fact,  with  the 
result  that  agitation  for  rate  reductions  will  naturally  ensue. 

This  matter  received  the  attention  of  the  Congress  of  Ac- 
countants held  at  St.  Louis  in  September,  1904,  and  the  atten- 
tion of  the  student  of  public  utility  accounting  is  therefore 
called  to  the  published  proceedings  of  the  Congress. 

It  is  not  amiss  in  this  connection  to  report  the  findings  of  a 
special  committee  appointed  to  pass  upon  this  subject. 

"The  committee  appointed  at  the  Congress  of  Accountants,  held  at 
St.  Louis,  U.  S.  A.,  in  September,  1904,  to  review  the  paper  by  Robert 
H.  Montgomery,  C.  P.  A.,  upon  'The  Importance  of  Uniform  Prac- 
tice in  Determining  the  Profits  of  Public  Service  Corporations  Where 
Municipalities  Have  the  Power  to  Regulate  Rates,'  having  taken  the 
paper  into  consideration,  have  come  to  the  following  conclusions,  and 
now  beg  to  state  the  same  as  their  opinion  upon  the  questions  raised : 

"  I.  A  distinction  must  be  made  between  the  profits  of  an  undertak- 
ing from  the  point  of  view  of  the  general  community  and  the  profits 
available  for  dividends  from  the  point  of  view  of  a  corporation  own- 
ing such  undertaking.     The  former  would  be  the  net  earnings  from 


PUBLIC  SERVICE  CORPORATIONS.  135 

the  operation  of  the  undertaking,  after  providing  for  all  waste  or 
depreciation  of  capital  assets  arising  directly  out  of  such  operation; 
while  the  latter  would  only  be  arrived  at  after  providing  also  for  any 
possible  loss  on  capital  assets  arising  from  causes  not  directly  inci- 
dent to  such  operation  and  for  interest  on  borrowed  money. 

"  II.  The  Net  Earnings  of  a  Public  Utility  with  which  the  general 
community  is  concerned  are  determined  by  the  excess  of  Gross  Earn- 
ings over  Expenses,  defining  the  latter  terms  as  follows: 

Gross  Earnings  consist  of  the  charges  for  all  services  rendered  dur- 
ing the  period  as  distinguished  from  mere  receipts,  but  would 
exclude  incidental  earnings  not  arising  out  of  the  operation  of 
the  utility,  such  as  interest  on  investments. 

Expenses  consist  of: 

(i)  The  direct  cost  of  operation  and  of  maintenance  (ordinary 
repairs),  expenses  of  management  and  provisions  for  bad  debts, 
damage  claims  and  rebates,  as  well  as  extraordinary  expenses  in- 
curred during  the  period,  such  as  legal  charges,  etc.,  but  they 
should  not  include  interest  on  borrowed  money,  discounts  on 
bonds  issued,  or  other  charges  in  connection  with  the  promotion 
or  financing  of  the  undertaking. 

(2)  Depreciation — 

(a)  On  plant — physical — covering  wear  and  tear,  including  di- 
rect requirements  for  renewals,  etc.,  arising  both  from  known  and 
probable  causes,  such  as  electrolysis,  &c. 

(b)  On  plant — indirect — due  to  obsolescence  and  the  like,  but 
not  that  dlue  to  a  fall  in  value  from  general  causes. 

(c)  On  other  capital  assets  which  are  diminishing  in  value  as- 
a  direct  result  of  the  operation  of  the  property,  such  as  moneys 
properly  expended  in  acquiring  from  the  local  authorities  the 
franchise  under  which  the  utility  is  operated  where  such  fran- 
chise is,  as  is  usually  the  case,  terminable  after  a  certain  number 
of  years;  or  cost  of  mines,  quarries  or  other  similar  properties 
which  are  being  used  up  continuously  for  the  purpose  of  operat- 
ing the  utility.  But  there  should  not  be  included  any  provision 
for  recouping  promoters'  profit  or  other  watered  capital,  or  for 
possible  loss  by  reason  of  a  general  fall  in  values,  &c.,  on  the 
purchase  at  the  end  of  the  franchise  of  the  whole  undertaking  by 
the  public  authorities,  i.  e.,  the  State  or  Municipality. 

"III.  In  dealing  with  the  private  accounts  of  a  corporation  operat- 
ing the  utility.  Earnings  will  also  embrace  miscellaneous  receipts,  if 


136  AUDITING. 

any,  not  connected  with  the  actual  operations  of  the  undertaking,  and 
the  following  additional  expenses  should  be  allowed  for,  before  ar- 
riving at  a  balance  available  for  distribution: 

(i)  Depreciation — An  additional  amount  to  cover  any  excess 
of  the  book  value  of  good-will,  franchise  and  plant  over  that  pro- 
vided for  under  Section  2,  sub-section  c  above,  or  over  the  sum 
it  may  be  expected  to  realize  on  the  expiry  of  the  franchise. 

(2)  Interest — On  bonds  or  other  funded  or  floating  debt. 

"  IV.  In  determining  the  rates  which  should  be  charged  to  the  pub- 
lic, regard  must  be  had  (a)  to  the  profit  ascertainable  under  Section 
II.,  and  {b)  to  the  further  charges  specified  under  Section  III.,  which 
would  have  to  be  borne  by  the  corporation  out  of  such  profits.  For 
instance,  if  eight  per  cent,  per  annum  on  the  capital  invested  is  con- 
sidered a  reasonable  rate  for  a  corporation  to  earn,  taking  into  con- 
sideration the  risks  in  Section  III.,  then  the  rates  should  be  fixed  so 
as  to  allow  of  a  profit  of  eight  per  cent,  calculated  as  laid  down  in 
Section  II.,  and  out  of  this  profit  the  corporation  would  have  to  pro- 
vide for  the  risks  and  expenses  stated  in  Section  III. 

A.  Lowes  Dickinson, 

Elijah  W.  Sells, 

Harvey  S.  Chase, 

Ernest  Reckitt, 

John  B.  Niven, 

Robert  H.   Montgomery,  Chairman." 

It  will  be  noticed  from  the  foregoing  that  the  most  important 
matter,  from  the  auditor's  point  of  view,  is  the  division  of  all 
expenditure  into  two  classes — capital  and  revenue.  It  is  not, 
however,  always  possible  for  the  auditor  to  judge  as  to  the 
correctness  with  which,  say,  the  cost  of  an  improvement,  or 
renewal,  has  been  apportioned  as  between  capital  and  revenue ; 
nor,  indeed,  is  it  necessary  that  he  should  attempt  to  constitute 
himself  an  engineering  expert.  He  will,  however,  require  to 
see  that  the  company's  engineer  has  certified  the  apportionment 
to  be  correct,  and  that  the  expenditure  on  capital  account  has 
been  properly  authorized.  In  addition,  it  is  desirable  that  he 
should  satisfy  himself  that  the  principle  followed  by  the 
engineer  in  arriving  at  his  apportionment  is  a  sound  one.  There 
is,  properly  speaking,  no  "  safe  side  "  in  these  matters — an 
undue  charge  to  capital  is  unfair  to  the  proprietors,  while  an 


PUBLIC   SERVICE   CORPORATIONS.  l^J 

undue  charge  to  revenue  is  (through  increasing  the  apparent 
cost  of  the  service  rendered)  an  injustice  to  the  consumers. 
The  following  examples  of  apportionment  will,  however,  be 
found  useful,  as  indicating,  in  general  terms,  the  correct 
method  of  arriving  at  the  amount  chargeable  against  capital, 
and  against  revenue,  in  any  special  case  that  may  arise : — 

New  Works  (including  extensions)  :  Capital. 

New  Works  in  Place  of  Old  Works:  Charge  original 
cost  of  old  works  pulled  down,  less  value  of  old  materials, 
against  revenue;  charge  the  remainder  against  capital.  (This 
amounts  to  debiting  capital  with  total  cost,  debiting  revenue 
and  crediting  capital  with  original  cost  of  old  works,  and 
crediting  revenue  with  value  of  old  materials  sold.) 

The  above  description  accurately  explains  the  theoretical 
apportionment  of  expenditure  on  renewals  as  between  capital 
and  revenue;  but,  for  practical  purposes,  it  is  important  to 
bear  in  mind  that  the  cost  of  any  kind  of  construction  work 
does  not  remain  constant  over  an  extended  period.  Assuming 
it  did  remain  constant,  no  modification  of  the  principle  already 
described  would  be  necessary;  but,  inasmuch  as  variations  in 
cost  are  to  be  expected,  it  is  claimed  by  many  practitioners  that 
only  the  bona  Ude  "  betterment "  can  be  properly  capitalized. 
Thus,  if  assets  which  originally  cost  $100,000  were,  on  renewal, 
to  cost  $125,000,  the  whole  of  the  cost  of  such  renewal  would 
be  a  revenue  charge.  If,  however,  the  assets  which  originally 
cost  $100,000  were  replaced  by  assets  of  a  higher  revenue- 
earning  capacity  at  a  cost  of  $150,000,  the  correct  method  of 
apportioning  this  $150,000  would  be,  in  the  first  place,  to  ascer- 
tain what  the  exact  re-instatement  of  the  original  assets  would 
have  cost,  to  charge  that  sum  to  revenue,  and  to  only  capitalize 
the  excess. 

There  is  reason  to  believe  that  in  the  past  this  rule  has  not 
always  been  applied  with  sufficient  strictness  to  all  companies. 
In  new  countries  the  cost  of  construction  work  has,  owing 


138  AUDITING. 

to  facilities  for  transport  and  improvements  in  methods,  been 
materially  reduced  of  late,  and  thus  the  question  arises  as  to 
whether  the  same  principles  may  be  fairly  applied.  If  they 
were  to  be  strictly  applied,  it  is  clear  that  pure  renewal  work, 
involving  no  "  betterment "  whatever,  would  indirectly  result 
in  a  credit  to  revenue,  in  that  the  original  amount  of  capital 
expended  would  be  maintained  in  spite  of  the  fact  that  capital 
assets  actually  existing  to  represent  it  had  cost  less.  Thus, 
an  asset  which  originally  cost  $100,000,  and  which  was  renewed 
(without  detriment)  at  a  cost  of  $80,000,  would  still  be  in- 
cluded in  the  capital  account  at  the  former  figure.  The  proper 
method  would,  imder  this  theory,  be  to  write  down  the  book 
value  of  the  capital  account  as  and  when  renewal  work  is 
undertaken  at  a  reduced  price. 

The  policy  which  is  more  generally  followed  in  the  United 
States,  however,  does  not  agree  with  the  foregoing  views. 
It  is  argued  that  the  best  practice  requires,  or  at  least  per- 
mits, the  plant  account  on  the  books  to  represent  the  last  cost ; 
that  is  to  say,  if  assets  which  originally  cost  $100,000,  on  re- 
newal cost  $125,000,  the  excess  is  properly  chargeable  against 
capital,  the  best  proof  of  the  soundness  of  this  position  being 
the  attitude  of  insurance  companies  with  respect  to  paying 
claims  for  fire  losses;  it  should  be  remembered  that  the  mat- 
ter of  insurance  is  a  vital  one  to  every  business ;  therefore,  the 
books  should  be  arranged  so  that  they  will  influence  a  fair 
settlement  in  case  of  fire,  provided,  of  course,  that  sound  ac- 
counting principles  are  not  violated.  The  theory  of  insurance 
is  that  the  insurance  company  will  bear  the  cost  of  replacing 
the  article  destroyed  (having  regard  to  its  condition  at  the 
time  it  was  destroyed)  ;  therefore,  if  the  books  show  the  last 
cost  of  the  plant,  it  will  be  easy  to  arrive  at  an  equitable  ad- 
justment by  using  the  book  values  less  a  faif  rate  of  depreci- 
ation. If  it  were  found  in  the  instance  cited  above  that 
$25,000  had  been  debited  to  revenue  and  the  asset  stood  on  the 
books  at  $100,000,  the  owner  would  probably  have  difficulty 
in  proving  his  claim  for  $125,000. 


GAS  COMPANIES.  139 

The  question  must  also  be  considered  from  the  standpoint 
of  the  return  which  a  public  service  corporation  would  be  en- 
titled to  earn  on  the  capital  invested.  It  would  certainly  seem 
that  the  depreciation  on  plant  which  forms  an  item  in  the  cost 
of  the  service  rendered  (see  Section  2,  sub-section  2  (a)  of 
Committee's  report,  page  135  hereof)  should  be  based  on  the 
cost  of  the  plant  actually  used  therefor,  which  would  neces- 
sarily include  the  last  cost  of  any  parts  of  the  plant  which 
might  have  been  replaced  since  the  inception  of  the  operation. 

In  other  words,  it  is  claimed  that  cost  is  the  only  correct 
basis,  for  it  must  be  assumed  that  an  undertaking  builds  or 
replaces  its  plant  at  the  lowest  cost  possible,  and,  if  through 
any  contingency,  commodities  increase  in  value  and  certain 
renewals  cost  more  than  the  original  assets,  it  is  quite  enough 
to  charge  the  latter  against  revenue  and  allow  the  asset  ac- 
count to  represent  actual  cost  of  the  existing  plant. 

Conversions. — In  case  old  materials,  instead  of  being  sold, 
are  used  for  other  purposes  on  the  works — treat  the  particular 
department  of  capital  expenditure  as  the  purchaser  of  the  old 
materials  in  question,  debiting  it  with  the  value  of  the  mate- 
rials and  the  full  cost  of  conversion  (if  any). 

There  are  some  special  features  connected  with  public  util- 
ity enterprises  which  will  be  considered  under  their  appropri- 
ate headings. 

(a)  GAS  COMPANIES. — The  income  of  a  gas  company 
consists  of  gas  sales,  residuals  sold,  and  generally  profit  on 
fittings  and  rents,  in  addition  to  interest  on  investments.  The 
collections  of  gas  sales  are  best  checked  in  totals  (care  being 
taken  to  fully  test  both  allowances  and  arrears),  the  total  re- 
ceivables being  arrived  at  from  the  meter  readings  books,  which 
will  show  the  total  amount  of  gas  consumed  and  what  meters 
are  in  use.  The  residuals  sold  cannot  well  be  checked  as  to 
quantity  (save  by  comparing  the  results  of  various  working 
statements),  but,  of  course,  the  auditor  may,  and  should,  check 
the  collection  of  the  amounts  debited.    The  same  remark  ap- 


140  AUDITING. 

plies  to  fittings,  which  will  almost  invariably  be  found  to  form 
a  part  of  a  gas  company's  business.  It  may  be  added  that  it 
is  best  merely  to  state  the  profit  arising  from  fittings  on  the 
credit  side  of  the  revenue  account  (rather  than  to  credit  rev- 
enue with  income,  and  to  debit  it  with  expenses).  The  leading 
items  of  expenditure  arise  from  coal  and  other  fuel,  stores, 
and  wages;  the  latter  has  already  been  considered  in  Chapter 
I.,  and  the  former  in  Chapter  IL,  and  need  no  further  con- 
sideration beyond  saying  that  both  must  be  fully  vouched,  and 
carefully  tested.  The  question  of  depreciation  should  be  care- 
fully considered  in  connection  with  gas  companies,  because 
a  considerable  part  of  the  plant  must  be  wholly  renewed  at 
comparatively  short  intervals.  A  provision  must,  therefore,  be 
made  for  these  renewals. 

The  investments  held  against  reserve,  insurance,  and  (if 
any)  depreciation  funds,  must  be  verified  by  an  inspection  of 
the  securities  held. 

This  leads  up  to  the  consideration  of  the  depreciation  fund 
(in  reality  a  sinking  fund),  which  must  be  accumulated  by 
companies  owning  works  on  leasehold  lands.  The  case  will 
not  often  arise,  but,  when  it  does  occur,  a  sufficient  sum  must 
be  set  aside,  and  invested  to  accumulate  to  the  cost  of  the 
works  by  the  time  the  lease  expires.  The  auditor  should 
satisfy  himself  as  to  the  sufficiency  of  the  annual  instalments. 

The  auditor  of  a  gas  company  should  be  thoroughly  familiar 
with  the  system  of  uniform  accounts  submitted  to  the  Amer- 
ican Gas  Light  Association  at  its  annual  meeting  in  1902,  and 
with  the  later  amendments  thereto.  The  report  covers  the 
**  Classification  of  Operating  Expense  Accounts;  Classification 
of  Betterments  or  Property  Accounts;  Forms  of  Monthly 
Journal  Entries  and  Rules  for  Closing."  While  certain  fea- 
tures of  this  system  can  be  improved  upon,  especially  the 
nomenclature,  it  forms  a  valuable  basis  for  an  ideal  system. 

The  Public  Service  Commissions  of  the  State  of  New  York 
have  issued  elaborate  classifications  of  accounts  for  gas  com- 


ELECTRIC  LIGHTING  COMPANIES.  I4I 

panics,  which  companies  operating  in  that  State  are  required 
to  use. 

(b)  WATER  COMPANIES.— The  audit  of  water  com- 
panies is  sHghtly  simpler  than  that  of  gas  undertakings,  by 
reason  of  the  fact  that  the  rates  charged  are,  for  the  most  part, 
fixed,  instead  of  fluctuating  with  the  quantity  used.  Such 
portion  as  is  suppHed  by  meter,  for  trade  purposes,  will  en- 
tirely follow  the  method  recorded  under  gas  companies.  With 
regard  to  the  greater  portion,  which  is  based  on  a  sliding 
scale,  it  is  not  usual  to  exhaustively  check  the  calculations  in- 
volved, but  they  should  be  tested  to  such  extent  as  may  appear 
desirable.  Vacancies  may  sometimes  be  vouched  by  a  declara- 
tion of  the  owner  that  the  property  in  question  has  been  vacant 
for  the  whole  of  the  quarter.  Allowances  (which  should  be 
very  exceptional)  must  be  properly  explained,  while  arrears 
and  bad  debts  must  both  receive  careful  attention. 

Most  companies  are  empowered  to  make  their  charges  in 
advance,  and  consequently  their  books  will,  at  the  date  of  the 
accounts,  reveal  a  profit  that  has  not  yet  been  earned;  due 
allowance  must,  of  course,  be  made  for  this  in  the  general 
balance  sheet. 

GAS  and  WATER  COMPANIES  (combined)  will— in 
almost  every  instance — ^be  found  to  keep  the  accounts  of  the 
two  undertakings  separate.  In  the  few  old  companies  where 
no  such  practice  exists,  separate  accounts  should,  at  least,  be 
made  out  for  capital  expenditure  and  revenue  (the  man- 
agement expenses  being  apportioned  according  to,  say,  the 
ratio  of  the  average  gross  income  from  each  department),  so 
that  the  profit  upon  each  may  be  known  and  the  proper  work- 
ing statistics  prepared. 

(c)  ELECTRIC  LIGHTING  COMPANIES.— The  gen- 
eral method  of  audit  will  practically  follow  the  lines  indicated 
under  the  head  of  Gas  Companies ;  especial  care  should,  how- 
ever, be  directed  to  the  correct  apportionment  of  expenditure 
between  capital  and  revenue. 


142  AUDITING. 

Care  should  be  taken  to  see  that  all  proceeds  of  sales  of 
lamps,  &c.,  are  accounted  for  and  proper  stock  accounts  kept. 

Electric  light  accounts  differ  from  those  of  most  other 
undertakings  in  that  the  perishable  nature  of  the  fixed  assets 
renders  it  imperative  that  special  attention  should  be  devoted 
to  the  subject  of  depreciation.  It  is  not  merely  sufficient  that 
the  working  plant  should  be  fully  maintained  in  a  state  of 
working  efficiency  out  of  revenue,  as  the  high  speed  at  which 
the  machinery  is  run,  combined  with  the  fact  that  only  the 
smallest  possible  intervals  of  rest  can  be  afforded  to  rectify 
defects,  very  materially  shortens  the  duration  of  the  life  of 
these  assets.  Moreover,  in  connection  with  this  particular  in- 
dustry the  advances  of  modern  science  are  so  rapid  that,  in 
spite  of  this  comparatively  short  time  of  life,  many  parts  of 
an  electrical  plant  become  obsolete  before  they  are  worn  out. 
For  these  reasons  a  high  rate  of  depreciation  must  be  provided, 
and  it  is  now  being  realized  that  in  most  cases  depreciation 
has  occurred  at  a  more  rapid  rate  than  has  been  provided  for 
in  the  accounts. 

It  is  thought  that  a  minimum  safe  provision  against  depre- 
ciation of  the  actual  expenditure  as  a  whole  would  be  one 
equal  to  five  per  cent,  on  the  total  capital  expenditure.  In 
the  English  editions  of  this  work  the  minimum  stated  is  four 
per  cent.,  but  general  opinion  seems  to  require  a  somewhat 
higher  rate  in  the  United  States.  It  may  be  added  that  five 
per  cent,  allowance  for  depreciation  on  the  entire  cash  invest- 
ment is  the  minimum  figure  used  by  a  prominent  American 
electrical  engineer  who  has  made  a  careful  study  of  condi- 
tions in  every  part  of  the  United  States;  in  the  case  of  one 
ten-million-dollar  plant  he  claims  that  the  annual  depreciation 
rate  should  be  nine  per  cent.  It  is  of  interest  to  note  that  of 
the  British  municipal  corporations  which  appear  to  have  been 
among  the  first  to  appreciate  the  importance  of  adequate  pro- 
vision for  depreciation,  Glasgow  provides — on  machinery, 
seven  and  one-half  per  cent.;  accumulators,  ten  per  cent.; 


STEAM  RAILWAYS.  143 

mains,  two  and  one-half  per  cent. ;  meters,  six  per  cent. ;  in- 
struments, five  per  cent. 

One  caution  in  conclusion  may  not,  however,  be  out  of 
place :  where  no  regular  purchase  ledger  exists — and  this  state 
of  affairs  will  also  be  frequently  found  in  connection  with 
both  gas  and  water  companies*  as  well — particular  care  will 
be  necessary  to  guard  against  any  omission  of  outstanding 
liabilities,  when  the  annual  accounts  are  prepared. 

V.     TRAFFIC    ACCOUNTS. 

(a)  STEAM  RAILWAYS.— Railwa^r  accounting  in  the 
United  States  has  reached  such  a  high  state  of  perfection,  that 
the  auditing  department  usually  has  at  its  head  a  thoroughly 
competent  official.  During  the  past  few  years,  audits  of  the 
accounts  by  professional  accountants  have  been  increasing  and 
it  is  thought  that  the  time  is  not  far  distant  when  railroad 
stockholders  will  not  be  satisfied  unless  an  independent  exam- 
ination  is  made  on  their  behalf.  Until  the  promulgation  of 
the  Interstate  Commerce  Commission's  revised  classification 
of  accounts  in  1907,  of  which  mention  has  already  been  made, 
it  was  not  customary  to  make  any  systematic  allowance  for 
depreciation,  and  there  is  still  a  remarkable  lack  of  uniforrnity 
with  regard  to  writing  off  so-called  betterments.  The  Com- 
mission has,  however,  issued  a  tentative  classification  of  Ad- 
ditions and  Betterments  Expenditures  which  will  doubtless  be 
succeeded  later  by  a  formal  classification  to  be  used  by  all 
roads.  If  definite  standards  of  extensions,  additions  and  bet- 
terments are  set  up  and  the  accounts  stated  accordingly,  this 
is  really  all  that  can  be  expected,  as  it  will  be  conceded  that,  if 
they  act  in  good  faith  and  violate  no  accounting  principles,  the 
directors  must  be  permitted  to  dictate  the  policy  of  the  com- 
pany, even  though  it  be  ultra-conservative.  If  the  stockhold- 
ers are  fully  informed  and  want  a  different  policy  pursued 
they  have  the  power  to  bring  about  a  change. 

A  few  remarks  on  the  routine  work  are  in  order:  The 
auditing  department,  in  itself,  constitutes  a  continuous  and 


144  AUDITING. 

thorough  check  upon  every  other  department  under  the  super- 
vision of  the  controller,  and,  as  no  moneys  whatever  pass 
through  that  office,  it  may  safely  be  taken  that  the  work  is 
honestly  performed. 

The  professional  auditor's  work  may  thus  be  said  to  com- 
mence with  the  certified  returns  of  traffic,  and  the  certified 
vouchers  for  expenditures  made.  He  must,  however,  himself 
examine  and  verify  the  summaries  of  these  items.  He  must 
see  that  they  tally  with  the  cash  and  notes  received,  and  that 
the  latter  find  their  way  into  the  bank  in  due  course.  He  must 
examine  the  vouchers  of  all  expenditure,  and,  so  far  as  pos- 
sible, verify  its  apportionment;  in  particular  must  he  satisfy 
himself  as  to  the  correctness  of  the  apportionment  of  such 
expenditure  between  capital  and  revenue.  With  regard  to  the 
issue  of  new  capital,  he  must  see  that  the  amount  actually  re- 
ceived agrees  with  the  totals  shown  in  the  stock  ledgers  kept 
at  the  secretary's  office.  He  should  compare  the  certified  re- 
turns of  "  foreign "  railways  with  the  entries  in  the  books 
of  his  own  company.  He  should  check  the  transactions  in 
notes  in  detail,  follow  the  matured  notes  into  the  banking 
account,  and  verify  the  outstanding  notes  by  the  inspection 
of  the  actual  documents.  He  must  check  the  traffic  outstand- 
ings with  the  certified  statements,  examine  the  entries  on  both 
sides  of  the  banking  account,  and  check  the  additions,  and, 
so  far  as  possible,  the  classification  of  the  items.  He  should 
examine  all  bonds  that  have  been  redeemed,  and  see  that  they 
have  been  cancelled.  He  should  also  see  that  all  paid  coupons 
have  been  cancelled  and  properly  filed.  He  should  examine 
the  accounts  for  repairs  made  to  the  rolling  stock  of  private 
car  lines  and  compare  the  lists  with  the  ledger.  He  should 
examine  the  accounts  of  rent  received,  thoroughly  check  the 
general  ledger,  compare  the  balances  of  the  various  stock  ac- 
counts with  the  certified  list  of  stores  on  hand,  and  compare 
the  totals  of  the  general  ledger  expense  accounts  with  the 
totals  of  the  subsidiary  books.  It  will  then  still  remain  for 
him  to  ascertain  that  such  liabilities  as  traffic  drawbacks  are 


ELECTRIC   RAILWAYS.  145 

provided  for,  verify  the  investments  by  inspection  of  securities 
and  examination  of  the  interest  received,  compare  the  capital 
issued  with  that  authorized  by  stockholders*  minutes,  give  a 
final  consideration  to  the  apportionment  of  capital  and  revenue 
expenditure,  and  see  that  the  necessary  certificates  have  been 
furnished  as  to  the  efficiency  of  the  permanent  way,  rolling 
stock,  &c. 

Of  course  all  of  the  above  details  cannot  be  covered  in  the 
audit  of  one  of  the  great  trunk  line  systems.  In  such  a  case, 
however,  the  internal  check  is  likely  to  be  more  efficient.  As 
with  other  undertakings,  the  auditor  must  be  governed  by  the 
special  circumstances  of  the  case,  and  should  only  omit  such 
details  as  are  checked  intelligently  by  independent  employees. 

Any  one  interested  in  the  accounts  of  steam  railways  should 
by  all  means  read  the  addresses  relating  thereto  by  Prof. 
Henry  C.  Adams,  in  charge  of  Statistics  and  Accounts,  Inters 
state  Commerce  Commission,  and  Arthur  W.  Teele,  C.P.A., 
delivered  before  the  meeting  of  the  American  Association  of 
Public  Accountants,  held  at  Atlantic  City,  October,  1908,  and 
which  appear  in  its  1908  year  book. 

(b)  ELECTRIC  RAILWAYS.— In  1898  the  Street  Rail- 
way Accountants*  Association  of  America  (now  known  as  the 
American  Street  and  Interurban  Railway  Accountants*  Asso- 
ciation) recommended  to  its  members  a  standard  classification 
of  accounts  prepared  by  a  committee  of  the  Association.  This 
classification  has  been  adopted  by  the  majority  of  street  rail- 
way companies  and  has  also  been  prescribed  by  quite  a  num- 
ber of  railroad  commissioners  for  use  in  making  reports  to 
the  State.  During  the  past  year  the  Interstate  Commerce  Com- 
mission has  issued  a  more  elaborate  classification  (at  least  for 
the  larger  corporations)  and  while  the  number  of  electric  rail- 
ways which  are  under  its  jurisdiction  is  comparatively  small, 
the  classification  may  come  into  general  use  through  being 
adopted  by  the  various  State  commissions  having  jurisdiction. 
The  New  York  Public  Service  Commissions  also  issued  re- 
vised  and   amplified  classifications   during   1908,  the  use  of 


146  AUDITING. 

which  is  compulsory  for  railways  operating  in  that  State ;  these 
classifications  were  patterned  to  a  considerable  extent  after 
that  of  the  Interstate  Commerce  Commission. 

The  auditor  should  make  himself  familiar  with  the  classifi- 
cation in  use  before  commencing  an  audit  of  a  street  railway. 
The  audit,  however,  is  rather  simple,  as  the  business  may  be 
said  to  be  on  a  "  cash  "  basis. 

The  audit  of  the  receipts  is  of  the  utmost  importance.  The 
daily  returns  will  usually  be  found  to  be  certified  to.  An 
examination  of  the  system  will  develop  whether  this  can  be 
depended  upon.  If  so,  the  daily  receipts  should  be  traced 
into  bank.  It  may,  perhaps,  seem  superfluous  to  suggest  the 
propriety  of  seeing  that  receipts  are  accounted  for  upon  every 
day  of  the  year.  It  will  be  found  in  nearly  all  cases  that  the 
entire  daily  receipts  are  deposited,  which  is,  of  course,  the 
only  proper  way,  and  if  it  should  not  be  in  force  the  change 
should  be  made  instantly.  Other  sources  of  receipts  should 
be  inquired  into,  and  it  may  prove  to  be  a  fruitful  inquiry,  for 
in  many  undertakings,  where  a  most  rigid  system  exists  of 
looking  after  the  usual  transactions,  infrequent  items  of  rev- 
enue, such  as  sales  of  old  materials,  &c.,  receive  scant  atten- 
tion, and  numerous  cases  are  known  of  these  sales  being  un- 
accounted for. 

The  question  of  the  proper  method  of  treating  ticket  sales 
is  also  one  to  be  considered  in  connection  with  railway  ac- 
counts. From  a  purely  theoretical  standpoint  there  can  be  no 
question  that  ticket  sales  only  become  actual  revenue  or  in- 
come when  the  service  to  which  the  purchasers  are  entitled  is 
rendered;  consequently  the  credit  arising  from  ticket  sales 
should  go  to  a  suspense  account  (stated  in  the  balance  sheet 
as  deferred  or  unearned  income)  and  transfers  made,  say 
monthly,  to  the  appropriate  earnings  account  for  the  tickets 
"  lifted.'* 

In  many  cases,  however,  where  the  ratio  of  ticket  sales  to 
cash  fares  is  small  the  outstanding  tickets  are  a  negligible 


ELECTRIC     RAILWAYS.  I47 

quantity.  In  other  cases,  however,  they  may  run  into  large 
amounts;  in  a  recently  published  balance  sheet  of  the  street 
railway  company  of  one  of  the  large  cities  the  liability  stated 
for  uncollected  tickets  was  over  $90,000.  Many  companies, 
however,  ignore  the  outstandings  entirely  and  include  the  en- 
tire amount  of  sales  in  the  current  earnings,  pointing  to  the 
example  of  the  steam  railroads,  with  which  this  custom  is 
nearly  universal,  as  a  justification  of  the  practice.  In  the  lat- 
ter connection  it  should  be  noted  that  the  Interstate  Commerce 
Commission  makes  an  exception  in  the  case  of  interchange- 
able mileage  books,  permitting  the  mileage  therein  to  be 
credited  to  earnings  only  as  honored. 

It  should  be  noted  that  the  inaccuracies  in  the  gross  earn- 
ings account,  due  to  the  failure  to  take  cognizance  of  uncol- 
lected tickets,  will  be  greatest  for  some  time  after  making 
changes  in  kinds  of  or  methods  of  selling  tickets,  also  when 
special  tickets  are  being  sold  for  a  limited  time. 

The  only  other  source  of  revenue  of  any  importance  will 
be  advertising;  but,  as  this  is  almost  invariably  sub-let  to  an 
advertising  agency,  it  needs  no  comment. 

The  expenditures — which  should  always  be  made  by  cheque, 
no  payment  out  of  traffic  receipts  being  on  any  account  per- 
mitted— must  be  carefully  vouched ;  while  the  analysis  thereof 
must,  so  far  as  possible,  be  verified.  In  particular,  the  appor- 
tionment between  capital  and  revenue  must  be  thoroughly 
scrutinized. 

It  is  only  a  few  years  since  street  railway  men  and  even 
some  professional  auditors  claimed  that  it  was  quite  unneces- 
sary to  provide  for  depreciation  in  street  railway  accounts.  By 
some  it  was  claimed  that  the  current  renewals  to  keep  the 
property  in  good  operating  condition  were  a  sufficient  charge 
to  operating  expenses,  while  others  claimed  that  the  enhance- 
ment in  the  value  of  the  franchises  held  offset  any  depreci- 
ation in  the  physical  property. 


148  AUDITING. 

If  the  directions  laid  down  in  the  uniform  system  are  prop- 
erly carried  out,  and  if  renewals  were  uniform  from  year  to 
year  over,  say,  twenty  years,  it  might,  perhaps,  be  claimed 
with  some  show  of  reason  that,  so  far  as  the  current  operat- 
ing accounts  at  least  are  concerned,  there  was  no  necessity  for 
providing  directly  for  depreciation. 

It  frequently  happens,  however,  that  the  first  examination 
the  auditor  makes  follows  immediately,  or  very  closely,  the 
reconstruction  of  the  road,  or  its  consolidation  with  other  lines, 
or  with  electric  light  companies.  During  this  period  the 
charges  to  construction  will  be  heavy — legitimately  so — and 
the  direct  charges  to  repairs  and  general  maintenance  light. 
It  is  contended  that  the  only  scientific  way  to  prepare  the  ac- 
counts of  such  a  year  is  to  include  an  allowance  for  depreci- 
ation. If  this  is  not  done,  it  almost  invariably  happens  that 
in  later  years,  when  the  renewal  charges  are  heavy,  the  neces- 
sity arises  for  capitalizing  these  large  expenditures,  and  where 
there  should  be  ample  reserve  to  provide  therefor,  laid  aside 
out  of  earnings,  there  is  not  a  dollar  in  hand  for  this  purpose, 
and  the  fact  that  the  dividends  paid  were  in  fact  out  of  capital 
develops  too  late. 

It  is,  however,  becoming  recognized  that  electric  railways 
are  no  exception  to  the  economic  rule  that  use  of  plant  is 
inseparable  from  depreciation  and  exhaustion.  It  is  immate- 
rial whether  the  plant  is  that  of  a  manufacturing  establishment 
or  that  of  a  railway ;  the  exhaustion  through  use  is  going  on 
just  as  surely  in  the  case  of  the  latter  as  in  the  case  of  the 
former.  Again,  there  is  probably  no  other  industry  in  which 
obsolescence  has  operated  to  render  property  useless  for  operat- 
ing purposes  more  rapidly  than  in  the  electrical  field.  The 
classification  of  accounts  recently  prescribed  for  electric  rail- 
ways by  the  New  York  Public  Service  Commissions  provides 
for  depreciation  charges;  the  Interstate  Commerce  Commis- 
sion's classification  likewise  takes  cognizance  of  the  necessity 
of  provision  for  depreciation.  Such  recognition  of  the  fact  of 
the  existence  of  depreciation  and  the  necessity  of  providing 


ELECTRIC  RAILWAYS.  149 

therefor  is  encouraging,  and  is,  in  some  measure  at  least,  a 
tribute  to  professional  accountants,  who  for  a  long  time  were 
almost  alone  in  their  stand  for  the  recognition  of  this 
principle. 

It  is  within  the  province  of,  and  it  is  in  fact  the  duty  of,  tlie 
professional  auditor  to  take  a  firm  stand  upon  this  question, 
and  to  refuse  to  certify  the  profit  and  loss  statement  of  a 
street  railway  company  which  does  not  amply  provide  for 
depreciation — either  directly  or  by  satisfying  himself  that  the 
charges  for  renewals  represent  a  fair  equivalent.  If  he  is  un- 
able to  secure  this  result  his  certificate  should  draw  prominent 
attention  to  the  fact,  and  it  must  follow  ultimately  that  the 
protest  will  be  heeded. 

The  opinion  of  an  engineer  on  the  question  of  depreciation 
of  electric  trolley  railways  is  of  value  to  professional  audi- 
tors. The  following  extract  is  from  a  report  made  by  a  promi- 
nent engineer.  The  undertaking  in  question  is  ai  small  one, 
but  it  is  not  likely  that  the  figures  would  be  altered  in  any 
event.  Pole  lines  and  copper,  ten  per  cent.;  ties,  twenty  per 
cent ;  machinery,  ten  per  cent. ;  cars,  twenty  per  cent. 

During  the  past  few  years  interurban  electric  railways  have 
developed  rapidly,  and  in  some  states,  particularly  in  the  mid- 
dle West,  there  is  now  a  perfect  network  of  them.  Running 
through  the  open  country — often  on  private  right  of  way  be- 
tween cities  and  town — they  frequently  have  a  mileage  com- 
paring favorably  with  that  of  the  smaller  steam  roads  and 
construction  equalling  steam  roads  standards.  In  addition  to 
the  short  haul  passenger  traffic  of  the  ordinary  urban  street 
railway,  there  is  long  distance  passenger  business  and  freight 
and  express  traffic  to  be  handled. 

These  conditions  necessitate  accounting  methods — and  con- 
sequently auditing  methods — which  approach  closely  those  in 
use  on  steam  roads.  Where  the  road  is  a  large  one  it  will 
naturally  have  an  auditing  staff  of  its  own  which  will  take  care  ■ 


150  AUDITING. 

of  the  routine  auditing  of  traffic  receipts,  and  the  professional 
auditor's  course  of  procedure  will  be  much  like  that  outlined 
under  (a)  Steam  Railways. 

(c)  SHIPPING  COMPANIES.— Unlike  the  accounts  of 
railways,  the  accounts  connected  with  marine  traffic  are  sub- 
ject to  no  uniform  recommendations  with  regard  to  form. 

There  are  comparatively  few  shipping  companies  operating 
in  the  United  States,  but  the  subject  is,  nevertheless,  of 
interest. 

There  is  no  essential  difficulty  in  connection  with  shipping 
accounts,  but  the  fact  that  it  is  both  desirable  and  customary 
to  show  the  net  result  of  every  voyage  of  every  ship  necessi- 
tates some  very  nice  apportionment  of  the  items  constituting 
shore  expenses  and  insurance. 

The  extent  of  an  auditor's  investigations  will  vary  greatly 
in  different  cases;  in  the  case  of  a  single  ship  it  is  desirable 
that  the  audit  be  as  exhaustive  as  possible;  but  in  the  case 
of  one  of  the  larger  companies  such  a  course  would  be  quite 
as  impracticable  as  in  the  case  of  a  railway.  The  actual  ex- 
tent in  any  particular  case  will  thus  be  very  largely  a  matter 
of  arrangement  and  of  expediency. 

The  following  considerations  may,  however,  be  safely  sub- 
mitted, as  they  will  in  every  case  require  to  be  dealt  with  in 
more  or  less  detail: 

Ascertain  that  freights  and  passage  money  are  duly  ac- 
counted for ;  that  the  apportionment  of  shore  expenses  is  equi- 
table; that  the  cost  accounts  are  not  improperly  manipulated 
(especial  care  being  required  where  one  cost  account  is  kept 
for  a  whole  fleet)  ;  that  only  structural  improvements  are 
debited  to  cost  account ;  that  proper  depreciation  is  allowed — 
especially  in  regard  to  boilers;  that  outstanding  freights  and 
agents'  balances  are  provided  for  in  accordance  with  the  docu- 
mentary evidence;  that  unclaimed  return  passages  are  in  or- 
der; that  proper  return  of  insurance  premiums  has  been  ob- 


SHIPPING  COMPANIES.  15 1 

tained  for  the  time  during  which  any  vessel  has  been  "  laid 
up,"  and,  generally,  that  insurance  matters  are  in  order;  that 
the  question  of  foreign  exchanges  has  been  dealt  with  upon  a 
proper  basis;  and  that  no  profits  are  taken  credit  for  on  ac- 
count of  uncompleted  voyages. 

In  order  to  prevent  misunderstanding,  it  seems  desirable  to 
point  out,  for  the  benefit  of  the  reader  who  has  no  experience 
of  shipping  accounts,  that  the  "  Cost  Account "  is  really 
neither  more  nor  less  than  a  capital  expenditure  account,  and 
must  on  no  account  be  confused  with  the  cost  accounts  kept  by 
manufacturers. 

Some  shipowners,  instead  of  insuring  with  underwriters 
against  risk  of  total  loss  or  damage  to  their  vessels,  raise  an 
insurance  fund  wherewith  to  meet  such  losses  by  periodical 
charges  against  revenue.  The  effect,  of  course,  is  that,  instead 
of  profit  and  loss  being  debited  with  insurance  premiums,  it 
is  debited  with  an  instalment — probably  somewhat  in  excess 
of  that  which  would  have  been  thus  paid — which  is  credited 
to  the  insurance  fund.  At  the  same  time,  to  make  the  insur- 
ance fund  really  effective  when  required,  it  is  desirable  that  a 
corresponding  amount  of  cash  should  be  invested  in  readily 
realizable  securities,  the  insurance  fund  thus  becoming  for  all 
practical  purposes  a  sinking  fund,  rather  than  a  mere  reserve. 
When  any  loss  is  incurred,  the  cost  of  replacing  it  is.  debited 
to  the  insurance  fund  account,  a  corresponding  amount  of  in- 
vestments being  realized  to  provide  the  necessary  cash.  It 
need  hardly  be  pointed  out  that  an  insurance  fund  can  only  be- 
come an  effective  provision  against  loss  in  the  case  of  com- 
panies owning  a  large  fleet  of  vessels,  so  that  within  their  own 
exi>erience  they  get  a  reasonable  average  of  risk.  Even  here, 
however,  it  will  sometimes  happen  that  a  loss  occurs  which 
will  more  than  swallow  up  the  whole  of  the  accumulated  fund, 
and  the  question  then  arises  whether  it  is  reasonable  to  bring 
forward  the  debit  balance  of  the  insurance  fund  account  as  an 
asset  upon  the  balance  sheet.  If  there  is  a  reasonable  prob- 
ability that  this  debit  balance  can  be  extinguished  out  of  future 


1.52  AUDITING. 

instalments  within  a  short  time,  there  might  possibly  be  no 
objection  to  this  course  of  procedure;  but,  in  any  event,  it 
seems  desirable  that  it  should  appear  as  a  special  item  in  the 
balance  sheet,  so  that  no  stockholder  may  be  deceived  as  to  the 
actual  position  of  affairs;  and  in  addition  the  auditor  should 
draw  attention  to  the  facts  in  his  report. 

Owners  of  single  ships  and  single-ship  companies  almost 
invariably  make  no  provision  for  depreciation;  the  auditor 
need  not  waste  his  time  upon  any  efforts  to  convince  his  clients 
of  the  imprudence  of  this  course,  but  he  should  not  forget  to 
append  the  necessary  qualification  to  his  report. 

The  auditor  of  single-ship  companies  must  bear  in  mind 
that,  as  regards  fraud,  there  is  no  such  thing  as  "  safety  in 
numbers  "  here,  for  the  accounts  are  usually  all  in  one  person's 
hands — let  him,  therefore,  not  omit  to  examine  the  voyage 
account  book  in  detail.  In  a  recent  case  it  transpired  that  the 
same  manager  had  control  of  the  funds  of  several  single-ship 
companies ;  and,  by  an  ingenious  process  of  "  ringing  the 
changes,"  was  enabled  for  many  years  to  conceal  from  the 
auditors  the  fact  that  there  were  serious  deficiencies  in  his 
cash  balance. 

It  is  a  good  plan  always  to  ascertain  that  no  mortgage  lias 
been  registered  against  the  ship  which  is  not  recorded  in  the 
books. 

The  professional  accountant  who  endeavors  to  acquaint  him- 
self with  all  of  the  ramifications  of  the  accounts  of  public 
service  corporations,  and  who  is  interested  in  the  subject  of 
municipal  v.  private  ownership,  will  find  it  necessary  to  read, 
or  at  least  consult,  the  voluminous  reports  of  the  National 
Civic  Federation  on  "  Municipal  and  Private  Operation  of 
Public  Utilities,"  issued  in  1907. 

VI.     THE    ACCOUNTS    OF  PUBLIC  AUTHORITIES. 

The  whole  subject  of  municipal  accounting  has  received 
consideration  attention  in  the  United  States  recently,  but  it 


PUBLIC    AUTHORITIES.  153 

cannot  be  said  that  there  is  any  immediate  prospect  of  the 
audit  of  these  accounts  in  general  being  turned  over  to  the 
professional  auditor.  It  is  sure  to  come  ultimately,  however. 
Therefore  serious  consideration  should  be  paid  to  this  subject. 

The  National  Municipal  League  has  done  much  to  further 
the  cause  of  uniform  municipal  systems,  and  the  St.  Louis 
Congress  of  Accountants  also  gave  the  matter  attention.  The 
proceedings  of  both  bodies  can  be  readily  secured,  and  should 
be  in  the  hands  of  everyone  interested.  When  it  is  considered 
that  practically  each  of  our  fifty  States  and  Territories  has  dif- 
ferent laws  regulating  the  affairs  of  municipalities,  the  vast 
work  undertaken  by  the  National  Municipal  League  will  be 
appreciated. 

The  United  States  Bureau  of  the  Census  has  during  recent 
years  taken  an  active  interest  in  this  subject,  and  through  its 
co-operation  with  the  other  agencies  which  are  working  for 
improved  municipal  accounting  methods  has  contributed  ma- 
terially to  the  progress  which  is  being  made.  The  Census 
Bureau's  classification  of  revenues  and  expenses,  based  on  that 
of  the  National  Municipal  League,  has  been  adopted  by  quite 
a  number  of  cities,  which  is  in  itself  an  encouraging  sign. 

With  such  an  extensive  field  and  complex  conditions  before 
him,  the  practitioner  who  has  in  mind  making  a  specialty 
of  municipal  accounting  will,  of  course,  be  compelled  to  make 
a  rather  exhaustive  study  of  the  whole  subject,  and  anything 
short  of  a  general  review  of  what  has  been  recently  accom- 
plished would  be  of  little  value;  it  is,  therefore,  unnecessary 
to  explain  that  the  limits  of  this  book  will  not  admit  of  further 
discussion. 

The  practitioner  or  student  who  desires  to  make  an  exhaus- 
tive study  of  municipal  accounting  would  do  well  to  secure  the 
various  reports  on  the  system  of  accounts  in  use  by  the  City 
of  New  York.  These  accounts  have  probably  received  more 
attention  than  any  other  accounting  system  in  existence.     In- 


154  AUDITING. 

vestigation  kas  followed  investigation,  and  out  of  them  all  a 
system  worthy  of  the  name  has  at  last  seen  the  light. 

The  Bureau  of  Municipal  Research  of  New  York  should 
have  the  principal  part  of  the  credit  for  this  result,  because 
its  directors  worked  unceasingly  for  several  years  to  bring 
about  the  much  needed  reforms. 

A  full  and  detailed  description  of  the  new  system  as  ap- 
proved by  the  Bureau  has  been  published  by  the  city,  and  any 
accountant  interested  can  no  doubt  secure  a  copy. 

It  is  believed  that  cities  not  nearly  so  large  as  New  York 
may  well  follow  some  of  the  new  features  recently  introduced, 
for — as  was  declared  by  the  Chamber  of  Commerce  of  New 
York  at  one  of  its  meetings — a  proper  system  of  accounts  will 
"  fix  responsibility,  expedite  business,  and  eHminate  waste." 

The  Chamber  of  Commerce,  in  its  desire  to  ascertain  whether 
or  not  the  proposed  system  was  based  on  these  theories  and 
was  working  out  as  well  as  was  promised,  appointed  a  com- 
mittee consisting  of  one  of  its  own  members,  together  with 
Francis  F.  White,  C.P.A.,  and  Robert  H.  Montgomery,  C.P.A., 
to  examine  and  report  thereon. 

This  committee  spent  several  months  in  its  investigation,  and 
its  report,  containing  a  number  of  criticisms  and  recommenda- 
tions, was  adopted  by  the  Chamber  of  Commerce  in  June,  1909. 

With  certain  exceptions,  chiefly  technical,  the  cominittee 
approved  the  system  in  the  following  terms: 

"We  unhesitatingly  assert  that  the  general  principles  upon 
which  the  new  accounting  system  rests  are  sound,  and  that 
their  application  to  the  accounts  of  the  city  cannot  but  be 
beneficial  to  a  marked  degree. 

"  The  substitution  of  a  thoroughly  co-ordinate  accounting 
system  for  the  unscientific  and  incomplete  one  that  has  pre- 
vailed will  not  only  pay  for  itself  by  enabling  the  Comptroller 
as  well  as  the  citizens  to  secure  a  knowled^-e  of  the  exact 


EXECUTORS  AND  TRUSTEES.  155 

financial  condition  of  the  municipality,  and  thus  furnish  the 
essential  data  to  secure  economical  administration,  but  will 
unquestionably  raise  the  credit  of  the  city." 

VII.     EXECUTORS'  AND_TRUSTEES'  ACCOUNTS. 

It  will  sometimes  happen  that  the  professional  accountant 
is  called  upon  to  audit  the  accounts  of  executors  or  trustees, 
on  behalf  of  some  dissatisfied  beneficiary,  or,  as  is  more  fre- 
quently the  case,  he  will  be  called  in  by  the  executors  or  trus- 
tees themselves,  because  they  desire  the  certificate  of  an  inde- 
pendent auditor  that  their  accounts  are  correct. 

The  purport  of  the  auditor's  investigation  in  such  cases 
will  be  to  ascertain  that  the  terms  of  the  will  or  trust  have 
been  complied  with,  and  that  no  improper  use,  or  unauthorized 
investment,  of  the  trust  funds  has  occurred.  Questions  of 
apportionment  between  principal  and  income  will  also  claim  his 
attention. 

The  fullest  investigation  into  details  will  be  necessary,  ex- 
cept, perhaps,  that  where  the  trustees  have  been  authorized  to 
carry  on  the  testator's  business  and  where  there  is  no  sug- 
gestion that  their  conduct  has,  in  this  respect,  been  improper, 
the  business   accounts   may  be   excluded   from   inquiry. 

In  addition  to  the  will  and  probate,  and  the  accounts  kept 
by  tho  executors  and  trustees,  the  accounts  filed  with  the  court, 
together  with  the  minute  book  (if  one  be  kept)  and  all  docu- 
ments and  vouchers,  will  require  to  be  carefully  examined. 

With  regard  to  the  question  of  apportionment,  it  is  import- 
ant to  remember  that  all  interest  accrued  to  the  date  of  death 
(inclusive)  forms  part  of  the  corpus;  that  the  profit  or  loss 
arising  from  any  subsequent  bona  iide  change  of  investment 
falls,  as  regards  principal,  upon  principal,  and  as  regards  in- 
come, upon  income ;  that,  even  where  investments  of  a  wasting 
nature  are  specially  authorized,  the  whole  of  the  income  does 
not  of  necessity  pass  to  the  life-tenant  (where  the  will  or  deed 


156  AUDITING. 

of  trust  provides  that  the  wasting  assets  must  be  administered 
for  the  equal  benefit  of  life-tenant  and  remainderman  the  usual 
custom  is  to  consider  five  per  cent,  (or  thereabouts)  as  income, 
and  to  capitalize  the  remainder)  ;  that  any  loss  arising  out  of 
an  unauthorized  investment  falls  upon  the  trustees  personally, 
who  are  liable  to  repay  the  amount  with  such  interest  as  the 
court  may  direct — the  rate  being  usually  six  per  cent,  (simple 
interest),  and  the  same  rate  is  usually  charged  where  the 
trustees  have  applied  the  funds  to  their  own  use.  Any  of  the 
above  provisions  may,  however,  be  modified  by  the  special 
terms  of  the  will  or  other  instrument  creating  the  trust. 

The  investments  authorized  for  trust  funds  (subject  to  any 
special  terms  in  the  will)  have  varied  from  time  to  time.  The 
auditor  will  therefore  require  to  satisfy  himself  that  each  in- 
vestment was  a  proper  one  at  the  time  it  zvas  made.  The 
investments  authorized  by  the  several  States  vary  as  to  their 
character,  but  usually  consist  of  first  mortgages  upon  real 
estate.  Government  and  first  lien  railroad  bonds. 

It  is  also  important  to  verify  the  commissions  claimed  or 
paid  to  the  executors  or  trustees,  both  as  to  amount  and  espe- 
cially to  make  sure  that  there  are  no  duplications.  An  execu- 
tor who  has  received  a  commission  on  the  principal  of  an 
estate  will  not  be  allowed  a  second  commission  for  subsequently 
acting  as  trustee  of  the  same  estate,  and  as  a  rule  no  commis- 
sion is  allowed  on  changes  in  investments. 

It  frequently  happens  that  an  estate  is  so  bequeathed  as  to 
be  divisible  between  persons  of  different  ages,  with  the  proviso 
that  the  share  of  each  is  to  be  held  in  trust  for  him  until  the 
happening  of  a  certain  event — such  as  his  attaining  his  majority 
(or,  in  the  case  of  a  female,  on  her  marriage) — the  beneficiary 
in  the  meantime  only  receiving  the  income  on  his,  or  her,  share. 
Under  such  circumstances  it  generally  follows  that  the  benefi- 
ciaries do  not  become  simultaneously  entitled  to  their  respective 
shares  in  the  principal ;  but  the  moment  any  one  becomes  en- 
titled to  a  share  in  possession  he  becomes  entitled  to  actually 


EXECUTORS   AND  TRUSTEES.  157 

receive  his  share,  and — save  by  consent — the  division  (or  par- 
tition) of  the  estate  cannot  be  postponed.  If  the  estate  consists 
of  investments  that  are  readily  capable  of  division,  the  problem 
is,  of  course,  a  quite  simple  one,  for  the  beneficiary  entitled  to 
the  partition  may  then  have  transferred  to  him  (or  sold  for  his 
benefit)  his  due  fraction  of  each  of  the  numerous  investments 
held  by  the  trustees;  but  when  the  estate  includes  mortgages, 
lands,  or  other  non-divisible  assets,  some  arbitrary  method  of 
arriving  at  the  beneficiary's  share  becomes  essential.  If  all 
beneficiaries  are  of  age,  the  share  of  each  may  be  mutually 
agreed ;  but  if  any  one  of  the  beneficiaries  be  under  age,  there 
is  no  means  of  obtaining  his  (or  her)  consent.  The  only 
course  is  then  to  apply  to  the  court  to  direct  a  "  partition  "  of 
the  estate,  and  the  ascertainment  of  the  share  immediately  pay- 
able to  the  beneficiary  entitled  to  a  possessory  interest,  and  the 
order  of  the  court  will  be  a  protection  to  all  parties  concerned. 
Upon  payment  of  the  amount  found  to  be  due  to  the  benefi- 
ciary, he  ceases  to  have  any  interest  in  the  trust  estate,  and  the 
residue  of  the  estate  is  then  held  in  trust  for  the  remainder 
of  the  beneficiaries,  who  alone  are  concerned  in  any  subsequent 
fluctuation  in  the  value  of  the  trust  investments. 

It  is  especially  important  to  remember  that  beneficiaries, 
unless  of  full  age,  have  no  power  to  consent  to  any  variation 
in  the  terms  of  the  trust. 

In  conclusion,  it  need  hardly  be  pointed  out  that  one  of 
the  most  important  duties  in  these  audits  consists  of  a  very 
careful  verification  of  the  investments. 


CHAPTER  V. 


SPECIAL  CONSIDERATIONS 
IN  DIFFERENT  CLASSES  OF  AUDITS. 


(Continued.) 


VIII.     ACCOUNTS  OF  INSTITUTIONS. 

(a)  CHARITIES.— Under  this  head  may  be  included  the 
accounts  of  hospitals,  certain  endowed  universities  and  schools, 
and  similar  institutions. 

The  distinguishing  feature  of  most  charities'  accounts  is  the 
receipt  of  subscriptions  and  donations.  These  will,  of  course, 
require  to  be  vouched  in  the  usual  way ;  but,  perhaps,  the  most 
effective  check  consists  in  the  publication  of  a  list  of  subscrib- 
ers and  donors  along  with  the  accounts. 

In  the  case  of  hospitals  there  will  be  a  considerable  revenue 
from  patients'  board,  &c.,  which  will  have  to  be  carefully 
checked.  It  is  not  always  the  custom  to  keep  these  accounts 
upon  a  double  entry  system,  and  abuses  frequently  occur. 

There  is  no  reason  why  the  patients'  accounts  should  not  be 
as  carefully  kept  and  easily  checked  as  the  accounts  of  guests 
in  a  hotel.  There  is  always  a  patients'  register,  giving  time  of 
arrival,  &c.,  and  the  other  books  can  be  arranged  conveniently 
to  allow  of  a  satisfactory  audit. 

It  is  unfortunate  that  the  accounts  of  institutions  receiving 
State  and  private  aid  should  be  lacking,  as  most  of  them  are, 

158 


ACCOUNTS    OF    INSTITUTIONS.  1 59 

in  uniformity  and  clearness.  It  is  hoped  that  the  increased 
attention  which  is  now  being  given  to  uniform  municipal  ac- 
counts will  extend  to  public  institutions,  and  great  benefit  may 
be  expected  in  this  direction. 

In  some  States  where  State  aid  is  given  to  hospitals  and 
other  charities  an  official  auditor  visits  the  recipients  and 
"  audits  "  the  accounts.  It  is  the  custom,  however,  for  these 
officials  to  simply  satisfy  themselves  that  the  State's  appropri- 
ation to  the  particular  institution  has  been  properly  expended, 
without  regard  to  other  sources  of  income  and  expenditure, 
and  the  books  are,  as  a  rule,  arranged  for  his  convenience. 
It  is  needless  to  say  that  such  a  system  does  not  lend  itself 
readily  to  the  preparation  of  proper  income  and  expense  ac- 
counts. On  the  whole  it  will  be  found  advisable  to  continue 
whatever  forms  the  State  examiners  may  require,  but  in  addi- 
tion there  should  be  installed  a  proper  system  which  will  show 
the  actual  results  of  operation  rather  than  a  simple  cash 
account. 

The  vouchers  will  probably  be  in  very  fair  shape,  as  it  is 
customary  to  have  them  examined,  not  only  by  the  State  exam- 
iners, but  by  committees  of  the  Board  of  Directors,  Managers, 
or  Trustees  as  the  case  may  be. 

(b)  CHURCHES. — In  many  respects  the  audit  of  church 
accounts  is  a  peculiarly  thankless  task.  Apart  from  the  fact 
that  they  are  hardly  ever  submitted  to  the  auditor  in  anything 
approaching  proper  form,  it  is  almost  invariably  the  case  that 
no  effective  internal  supervision  is  exercised,  and  frequently 
large  sums  will  pass  through  a  Treasurer's  hands  without  any 
proper  check  being  kept  upon  his  dealings. 

The  auditor  must  check  everything  he  can,  and  try  to  teach 
his  clients  the  elements  of  commercial  caution ;  but  it  is  prob- 
able that  he  will  never  feel  quite  happy  with  a  church  audit. 

At  a  recent  church  convention  it  was  proposed  in  good  faith 
by  a  disinterested  individual  that  in  all  parishes  having  a  cer- 


x6o  AUDITING. 

tain  minimum  income,  the  treasurer's  accounts  be  submitted  to 
a  Certified  Public  Accountant  for  audit.  Unfortunately  the 
motion  was  voted  down,  but  the  seed  has  been  sown,  and  no 
doubt  the  harvest  will  ripen  at  no  distant  date. 

(c)  COLLEGES  AND  SCHOOLS.— These  accounts  call 
for  but  little  comment.  The  usual  method  of  audit  may  be  said 
to  consist  of  a  "  cross  "  between  that  employed  in  "  Chari- 
ties "  and  "  Hotels  "  (q.  v.),  but  it  may  be  added  that  only  a 
detailed  audit  is  likely  to  be  found  entirely  satisfactory. 

The  income  from  tuition  fees,  room  rents,  &c.,  forms  a 
large  aggregate  as  a  rule,  but  is  usually  recorded  by  single 
entry  methods,  and  it  therefore  will  bear  careful  checking. 
Obviously  every  student's  name  found  in  the  annual  catalogue 
must  be  accounted  for,  and  it  is  sometimes  found  to  be  a  good 
plan  to  report  to  the  trustees  all  allowances  and  rebates,  and  the 
names  of  all  "  free  "  students.  It  may  serve  as  a  surprise  to 
the  deans,  but  the  trustees  will  probably  appreciate  the  report. 

While  it  is  not  unusual  for  colleges  to  have  professional 
audits,  there  is  a  wide  difference  in  the  methods  adopted  of 
stating  the  accounts,  and  there  is  a  vast  field  for  improvement. 
Most  of  the  balance  sheets  and  income  and  expense  accounts 
are  stated  in  such  an  involved  way  that  it  is  hard  to  gather 
any  definite  information  as  to  the  actual  results  of  the  "  opera- 
tions." In  view  of  the  immense  sums  which  are  contributed 
annually  it  is  to  be  regretted  that  more  attention  is  not  given 
to  the  accounts  for  the  purpose,  at  least,  of  showing  by  com- 
parisons and  proofs  that  there  has  been  a  reasonable  return 
from  the  "  capital  "  employed. 

It  is  possible  that  college  accounting  methods  may  undergo 
a  radical  improvement  in  the  near  future.  The  deficiencies  of 
present  methods  are  clearly  set  forth  in  a  series  of  articles  by 
Clarence  F.  Birdseye,  Esq.,  published  in  The  American  College, 
and  commencing  with  October,  1909.  The  student  will  do  well 
to  consult  the  articles  "  College  Bookkeeping  and  Accounting  " 
and  "  Analyzing  the  College  Business." 


BUILDING   AND   LOAN    ASSOCIATIONS.  l6l 

IX.     BUILDING  AND  LOAN  ASSOCIATIONS. 

The  number  of  frauds — some  of  them  of  disastrous  pro- 
portions— that  have  occurred  in  the  accounts  of  building  asso- 
ciations should  suffice  to  make  the  auditor  of  these  accounts 
more  than  usually  cautious. 

Although  so  far  as  known  all  these  associations  require  the 
appointment  of  auditors  annually,  it  has  not  been  the  custom 
to  employ  Certified  Public  Accountants,  chiefly  on  account  of 
the  expense  involved,  but  in  view  of  the  losses  which  have 
fallen  upon  stockholders  in  the  past,  it  would  seem  that  by  this 
time  an  investor  would  no  longer  be  satisfied  with  the  amateur 
auditor.  In  any  event,  the  auditor's  fee  would  not  be  more 
than  a  small  fraction  of  the  association's  annual  income,  and 
if  the  matter  could  be  put  before  the  investors  in  a  proper  light 
the  great  majority  no  doubt  would  insist  on  proper  audits. 

It  will  usually  be  found  that  the  whole  management  of  a 
building  association  devolves  upon  one  man,  who — besides  hav- 
ing both  books  and  cash  under  his  entire  control — turns  the 
whole  of  the  board  round  his  little  finger.  Add  to  this  the 
fact  that  the  system  of  bookkeeping  employed  is  often  of  the 
most  primitive  kind,  and  some  idea  of  the  responsibility  of  the 
auditor's  position  may  be  gained.  The  complexion  of  affairs 
is  hardly  improved  where  there  is  more  than  one  real  worker 
upon  the  staff ;  any  efficient  system  of  internal  check  is  all  but 
unknown  (except  in  a  few — a  very  few — of  the  best  and  larg- 
est associations),  while  the  class  of  men  employed  is  usually 
very  different,  and  very  inferior,  to  the  class  of  men  employed 
in  banks  for  work  of  a  very  similar  nature. 

The  great  majority  of  frauds  that  have  been  committed 
have  remained  undetected  by  reason  of  the  very  superficial'ex- 
amination  bestowed  upon  the  accounts  by  the  auditors;  but 
cases  have  occurred  in  which  the  most  detailed  audit  (con- 
ducted by  unskilled  men  truly,  but  none  the  less  detailed  on 
that  account)  has  failed  to  detect  anything  wrong. 


l62  AUDITING. 

The  authors*  experience  with  building  association  accounts 
has  convinced  them  of  the  extreme  importance  of  making  the 
audit  thereof  in  considerable  detail;  of  carefully  verifying 
every  amount  received  in  redemption  of  mortgages  or  paid 
out  to  investing  stockholders;  of  comparing  every  pass  book 
with  the  ledgers^  and  both  with  the  lists  of  balances;  and  of 
testing  the  latter  at  considerable  length  in  respect  of  the  cal- 
culation of  interest.  The  income  received  from  properties  on 
hand  must  be  verified  in  every  possible  way ;  and,  where  such 
income  does  not  seem  to  be  a  fair  return  upon  the  book-value 
of  the  various  properties,  the  latter  should  be  either  revised  or 
supported  by  independent  valuation. 

The  papers  relating  to  all  mortgages,  and  the  securities  relat- 
ing to  whatever  other  investments  there  may  be,  must  also 
be  examined  by  the  auditor,  who  will  do  well,  in  addition,  to 
require  the  attorney  to  certify  that  such  papers  are  all  in  order. 

In  the  case  of  a  building  association  of  any  pretensions,  the 
number  of  deeds  and  mortgage  papers  that  call  for  inspection 
will  be  very  considerable,  and  accordingly  a  method  of  saving 
unnecessary  labor  will  be  found  acceptable.  In  all  well- 
managed  concerns  it  will  be  found  that  the  papers  relating  to 
each  separate  mortgage  are  enclosed  in  a  separate  envelope, 
upon  the  outside  of  which  is  endorsed  a  resume  of  its  con- 
tents. If  this  endorsement  has  once  been  verified  and  the 
envelope  has  been  sealed,  it  is  thought  that  under  normal  cir- 
cumstances no  similarly  detailed  verification  of  the  contents 
is  necessary  at  subsequent  audits.  At  each  subsequent  audit  all 
fresh  sets  of  papers  must,  of  course,  be  verified  in  detail,  as 
must  also  the  contents  of  those  envelopes  which  for  one  reason 
or  another  have  been  opened  during  the  current  period,  and 
upon  which,  therefore,  the  auditor's  seal  is  not  intact;  but  it 
is  thought  that  where  the  seal  remains  intact,  and  where  a  suffi- 
ciently distinctive  seal  has  been  employed,  any  further  detailed 
investigation  is  unnecessary.  It  should  be  sufficient  for  prac- 
tical purposes  to  verify  the  contents  of  a  few  envelopes,  taken 
at  random,  and  also  of  course  the  contents  of  all  envelopes 


BUILDING  AND  LOAN   ASSOCIATIONS.  163 

which  in  the  opinion  of"  the  auditor  may  by  any  possibility 
have  been  tampered  with. 

The  annual  statement,  printed  copies  of  which  are  usually 
distributed  among  the  stockholders,  should  be  carefully  veri- 
fied. Some  associations  include  in  this  statement  a  schedule 
of  the  account  numbers  and  amounts  of  dues  and  interest 
either  in  arrears  or  paid  in  advance.  This  is  an  excellent  plan 
and  should  be  in  general  use. 

The  basis  on  which  profits  are  apportioned  among  the  differ- 
ent series  of  stock  should  also  receive  attention.  Various 
plans  are  employed,  some  of  which  are  clearly  misleading. 
E.  g.,  by  one  plan  the  percentage  of  profit  earned  during  the 
year  is  calculated  on  the  paid  in  dues  only,  ignoring  the  profits 
earned  during  previous  years  on  unmatured  series  and  em- 
ployed as  part  of  the  association's  capital  during  the  current 
year. 

This  method  results  in  showing  a  much  larger  earning  rate 
than  is  actually  the  case.  An  investigation  of  the  accounts  of 
associations  which  claim  to  be  earning  seven  and  eight  per  cent., 
or  even  more,  per  annum  usually  discloses  the  fact  that  the 
percentage  of  profits  is  calculated  on  the  basis  mentioned  above 
and  the  actual  rate  per  annum  is  considerably  less.  Of  course, 
if  the  association  by-laws  distinctly  provide  for  such  a  basis  of 
apportionment,  the  auditor  can  do  nothing,  but  if  the  basis  is 
not  clearly  defined  in  the  by-laws  the  auditor  should  urge  the 
adoption  of  a  plan  which  is  both  accurate  and  equitable. 

It  is  more  than  probable  that  the  fees  attaching  to  his  office 
will  afford  the  auditor  no  adequate  remuneration  for  an  exam- 
ination conducted  on  such  lines  as  those  laid  down ;  but,  be  this 
as  it  may,  the  auditor  who — under  ordinary  circumstances — 
omits  any  of  the  precautions  named  would  be  worse  than  fool- 
ish. 

It  must  also  be  remembered  that  there  is  usually  a  statutory 
limit  to  the  borrowing  powers  of  a  society,  which  must  not  be 
exceeded. 


164  AUDITING. 

X.    PROFESSIONAL  ACCOUNTS. 

(a)  LAWYERS.— It  is  not  easy  to  effectively  audit  the 
accounts  of  lawyers  without  devoting  considerably  more  time 
to  the  task  than  clients  would  be  willing  to  pay  for,  and  noth- 
ing short  of  a  continuous  audit  appears  to  meet  the  necessities 
of  the  case. 

Almost  all  lawyers  use  the  stock  forms  of  books  sold  by  law 
stationers,  and  these  are  designed  rather  to  save  time  than 
for  any  other  purpose,  and  as  framed  it  is  difficult  to  audit 
them. 

The  amount  included  in  the  balance  sheet  for  outstanding 
charges  should,  in  general,  be  verified  by  comparison  with  the 
draft  bills  of  costs.  Agents'  accounts  should,  at  all  times,  be 
carefully  considered,  and  it  is  not  a  bad  plan  to  compare  every 
item  of  costs  charged  up  with  the  copy  of  the  bill  rendered,  the 
object  being  to  make  sure  that  the  full  amount  chargeable  has 
been  debited,  for  the  amount  asked  for  may  not  (by  reason  of 
an  amount  having  been  received  on — or  in — account)  be  al- 
ways the  amount  that  has  to  be  debited. 

Of  recent  years  the  increasing  number  of  fraudulent  fail- 
ures and  defalcations  on  the  part  of  lawyers  has  drawn  atten- 
tion to  the  importance  of  proper  accounts  being  kept  by  those 
who  wish  to  avoid  any  possible  reflection  upon  their  manner 
of  dealing  with  the  moneys  entrusted  to  them  by  their  clients. 
It  is  impossible  to  overstate  the  importance  of  keeping  clients' 
money  entirely  distinct  from  the  moneys  of  the  practitioner 
himself,  while  it  may  be  added  that  in  many  respects  it  mate- 
rially simplifies  the  keeping  of  the  accounts.  Each  large  estate 
should  have  its  own  separate  bank  account  and  separate  books, 
entirely  independent  of  the  books  of  the  firm,  while  all  other 
moneys  received  in  trust  for  clients  should  be  paid  into  a 
"  Clients'  Account,"  and  a  separate  column  provided  in  the 
cash  book  for  keeping  this  account  distinct  from  the  "  general  " 
bank  account.     Not  the  least  important  advantage  of  keeping 


ARCHITECTS.  1 65 

the  accounts  of  large  estates  quite  separate  from  the  general 
accounts  is  that  the  cost  of  keeping  them,  and  of  having 
them  audited,  may  then  frequently  be  charged  against  the 
estate  in  addition  to  other  costs.  Moreover,  these  accounts  can 
be  submitted  to  the  clients  (or  their  agents)  for  audit  without 
disclosing  any  other  transaction;  and  if  they  be  so  audited  at 
regular  intervals,  it  is  frequently  unnecessary  for  them  to  be 
also  audited  by  the  lawyers'  auditors,  and  by  this  means  a 
further  saving  of  expenses  may  be  effected. 

(b)  ARCHITECTS.— The  accounts  of  architects  are,  per- 
haps, not  frequently  the  subject  of  professional  audit,  but  this 
is  a  state  of  affairs  which  is  always  undesirable,  and  particu- 
larly so  in  cases  where  two  or  more  architects  are  practising 
in  partnership. 

The  accounts  do  not,  as  a  rule,  involve  a  particularly  volu- 
minous record,  and  it  is  therefore  desirable  that  in  all  cases 
the  audit  should  be  a  detailed  one.  The  fact  that  architects  are 
frequently  not  business  men  makes  it  important  that  the  audi- 
tor should  take  every  precaution  to  guard  his  client  from  loss, 
both  through  actual  fraud  and  bad  bookkeeping ;  it  is  therefore 
important  for  him  to  see  that  every  item  in  the  cash  book  is 
properly  vouched,  and,  so  far  as  possible,  that  all  fees  and 
commissions  are  duly  accounted  for.  It  may  Be  mentioned 
here  that,  with  regard  to  fees  payable  to  an  architect  for  super- 
vising the  erection  of  buildings,  these  fees  are,  as  a  rule,  pay- 
able by  way  of  a  commission  upon  the  value  of  the  work  done, 
as  certified  by  the  architect  for  the  purpose  of  assessing  the 
payments  to  be  made  on  account  to  the  builder.  There  will  al- 
ways, at  balancing  time,  be  a  considerable  amount  of  accruing 
fees,  which,  although  not  actually  due  for  payment  at  the  time, 
constitutes  an  asset;  a  schedule  of  these  items  should  be  pre- 
pared and  certified  by  the  principals  for  inclusion  in  the  ac- 
counts. Many  practitioners,  however,  work  their  accounts  ex- 
clusively upon  a  cash  basis,  and  the  plan  has  much  to  recom- 
mend it  when  professions  are  concerned. 


l66  AUDITING. 

In  all  important  undertakings  in  England,  a  "  Clerk  of  the 
Works  "  is  appointed  to  be  on  the  spot,  for  the  purpose  of 
checking  the  material  and  workmanship  employed  by  the  build- 
er. The  clerk  of  the  works  is  not  infrequently  appointed  by 
the  architect,  but  he  is  invariably  paid  by — and  is  the  servant 
of — the  architect's  client ;  if,  therefore,  for  reasons  of  conveni- 
ence, his  salary  has  been  paid  by  the  architect,  it  is  important  to 
see  that  it  is  subsequently  recovered  by  him.  This  practice  is 
not  generally  followed  in  the  United  States,  but  it  has  much  to 
commend  it,  and  in  some  respects,  at  least,  the  plan  will  no 
doubt  be  adopted  here  ultimately. 

(c)  MEDICAL  MEN. — ^There  are  so  many  different  sys- 
tems of  bookkeeping  employed  by  medical  men  that  it  is  diffi- 
cult to  afford  any  useful  hints  as  to  the  method  of  audit  in  the 
space  here  available.  It  may  be  pointed  out,  however,  that 
it  is  not,  as  a  rule,  either  necessary  or  expedient  for  the  auditor 
to  go  behind  the  debits  in  the  patients'  ledger,  which,  as 
often  as  not,  are  fixed  at  round  sums  by  the  practitioner  with- 
out any  strict  reference  to  the  number  of  visits.  It  is  desirable, 
however,  that  the  auditor  should  see  that  some  efficient  system 
of  recording  visits  is  in  force,  so  that  his  client  has  all  the 
facts  before  him  when  assessing  the  amount  of  his  charges. 
The  auditor  should  carefully  check  the  credit  side  of  the 
patients'  ledger,  noting  in  particular  any  allowances  that  have 
been  made,  and  he  should  see  that  all  cash  credited  to  patients 
has  been  properly  accounted  for. 

Where  payments  have  been  made  on  account  of  patients, 
whether  for  medicines,  or  for  consultation  fees,  &c.,  it  is  very 
important  that  the  auditor  should  see  that  they  are  properly 
charged  up  and  collected  in  due  course.  Many  practitioners 
employ  one  or  more  assistants,  or  dispensers,  who  are  author- 
ized to  receive  money,  and  where  this  is  the  case  it  is  especially 
important  that  the  system  in  use  should,  as  far  as  possible, 
follow  the  ordinary  commercial  precautions  against  fraud. 
With  those  practitioners  who  supply  their  patients  with  medi- 
cines, it  is  also  necessary  that  the  accounts  of  druggists,  &c., 


MEDICAL    MEN.  167 

should  be  carefully  checked,  and  an  allowance  will  have  to  be 
made  at  balancing  time  for  the  value  of  drugs  in  stock. 

It  need  hardly  be  added  that  where  horses  and  carriages  or 
automobiles  are  the  property  of  the  practitioner,  an  adequate 
allowance  must  be  made  for  depreciation,  at  the  rate  of  fifteen 
to  thirty  per  cent,  per  annum.  Where,  however,  these  are 
rented  it  is  equally  important  to  see  that  the  cost  of  hire  to 
the  date  of  balancing  is  included;  or,  if  this  has  been  paid  in 
advance,  that  a  proportionate  part  is  held  over  as  an  asset. 


In  concluding  this  portion  of  the  work,  the  authors  cannot 
but  feel  that  in  spite  of  the  very  considerable  space  that  has 
been  devoted  to  the  consideration  of  the  special  features  attach- 
ing to  the  audit  of  different  classes  of  accounts,  the  subject  has 
been  only  very  imperfectly  dealt  with.  When,  however,  it  is 
remembered  that  an  exhaustive  treatise  upon  the  audit  of  any 
one  class  of  accounts  might  easily  approach  the  dimensions  of 
the  whole  of  the  present  work,  it  is  hoped  tht  it  will  be  con- 
ceded that — ^however  desirable  it  might  have  been  to  have 
considered  the  various  questions  involved  at  further  detail — 
more  could  not  have  been  reasonably  expected  within  the 
limits  of  this  volume. 


CHAPTER  VI. 


FROM    TRIAL    BALANCE    TO    BALANCE 

SHEET. 


That  which  forms  the  most  important  part  of  every  audit, 
namely,  the  questions  of  principle  involved  in  the  preparation 
and  certification  of  the  balance  sheet  and  trading  and  profit 
and  loss  accounts  from  the  trial  balance,  will  now  be  consid- 
ered. It  is  especially  desirable  that  in  every  audit  the  prin- 
cipal should  give  these  subjects  his  personal  consideration,  not 
merely  because  of  their  intrinsic  importance,  but  also  from 
questions  of  policy  which  have  already  been  dwelt  upon. 

As  the  points  now  about  to  be  discussed  are  the  most  im- 
portant, so  are  they  also  the  most  debatable,  accountants  of 
the  highest  repute  being  by  no  means  agreed  as  to  several  of 
the  principles  involved.  On  the  other  hand,  it  would  seem 
to  the  acute  observer  that  much  of  this  apparent  difference  is, 
m  reality,  merely  verbal,  while  perhaps  more  is  due  to  the 
inherent  difficulty  that  exists  in  casting  abstract  principles  into 
a  concrete  form.  It  is,  indeed,  not  unreasonable  to  suppose 
that,  in  any  particular  case  which  might  be  named,  there  would 
not  exist  among  our  leading  practitioners  any  radical  difference 
of  opinion  as  to  what  the  profit  of  a  company  had  really  been ; 
the  real  cause  of  the  confusion  appearing  to  be  that,  while 
one  maintains  the  true  net  profit  to  be  deducible  from  the 
profit  and  loss  account,  another  maintains  that  the  balance 
sheet  is  the  only  reliable  basis.  It  would  seem  that,  if  both 
balance  sheet  and  profit  and  loss  account  be  correct,  it  matters 
but  little  which  is  called  the  cause  and  which  the  effect. 

i68 


1 

PRINCIPLE  IN  VALUATION   OF  ASSETS.  169 

Throughout  the  course  of  this  chapter  the  endeavor  will  be 
to  view  the  various  questions  of  principle  from  the  broadest 
possible  standpoint.  It  is  true  that,  by  this  means,  the  inherent 
difficulty  of  the  considerations  involved  will  not  be  escaped ;  but 
it  is  hoped  that  at  least  the  treatment  will  be  found  free  from 
catchwords  and  all  other  sources  of  superfluous  mystification. 

PRINCIPLE  IN  VALUATION  OF  ASSETS. 

It  being  the  primary  object  of  most  ordinary  undertakings 
to  continue  to  carry  on  operations,  it  is  but  fair  that  the  assets 
enumerated  in  a  balance  sheet  be  valued  with  that  end  in 
view. 

Taking  first  the  case  of  private  traders,  whether  sole  or 
firms,  it  is  not  difficult  to  see  that,  inasmuch  as  no  man  can 
reasonably  hope  to  live  forever,  the  business  of  such  an  one 
is  ephemeral  as  compared  with  that  of  a  corporation.  It  is 
true  that  the  business  may,  and  frequently  does,  live  longer 
than  its  founder ;  but  to  do  so  involves  a  change  of  proprietor- 
ship, and  with  it  a  re-valuation  of  assets.  It  will  thus  be  seen 
that,  although  there  is  no  necessity  to  consider  the  contingency 
of  liquidation  (at  what  are  expressively  known  as  "  knock- 
down "  prices),  not  merely  the  contingency  but  also  the 
eventual  certainty  of  a  re-valuation  must  be  faced.  The  basis 
of  such  a  valuation  will  be  that  known  as  "  a  going  concern," 
and  it  will,  perhaps,  be  worth  while  to  consider  the  meaning  of 
this  phrase.  So  far  as  it  possesses  any  definite  meaning — for, 
of  necessity,  the  term  is  an  elastic  one — the  qualification  im- 
plies "  at  such  a  value  as  they  would  stand  in  the  books  if 
proper  depreciation  had  been  provided  for  " — ^the  term  "  depre- 
ciation "  being  taken  to  represent  the  amount  by  which  the 
value  of  an  asset  has  become  reduced  by  effluxion  of  time  or 
wear.  A  fluctuation  in  value  caused  by  external  circumstances 
will,  however,  also  require  to  be  taken  into  consideration  when 
property  changes  hands.  It  is  important  to  remember  that  it 
is  not  really  practicable  to  so  maintain  the  efficiency  of  assets 
that  no  depreciation  shall  ever  occur. 


170  AUDITING. 

The  accounts  of  incorporated  companies  next  claim  atten- 
tion. These  companies,  having  a  perpetual  succession,  are, 
perhaps,  entitled  to  be  considered  theoretically  permanent 
(although,  in  practice,  they  are  often  much  shorter-lived  than 
private  enterprises). 

In  the  case  of  a  corporation,  however,  it  must  be  borne  in 
mind  that,  whereas  a  private  firm  is  under  no  obligation  to 
retain  the  whole  of  its  undertakings  intact,  the  laws  of  our 
various  States  do  not  allow  dividends  to  be  paid  out  of  capital, 
and  this,  of  course,  directly  affects  the  question  of  permanency. 
It  is  also  of  more  importance  in  the  case  of  corporations  to 
distinguish  between  what  are  and  what  are  not  fixed  assets. 

This  is  a  point  upon  which  even  accountants  might  not 
always  be  agreed,  while  the  recent  statement  of  an  English 
judge,  that  blast  furnaces  owned  by  a  smelting  company  must 
be  regarded  as  part  of  its  current  assets,  emphasizes  the  im- 
portance of  a  system  of  accounts  which  may  be  as  independent 
as  possible  of  any  necessity  of  definitely  distinguishing  between 
fixed  assets  and  current  assets.  Incidentally  it  may  be  men- 
tioned that  the  terms  most  commonly  used  by  lawyers,  "fixed 
capital'*  and  "floating  (or  circulating)  capital,"  are  clearly 
incorrect.  The  capital  of  a  company  is  that  which  has  been 
contributed  for  the  purpose  of  enabling  it  to  carry  out  the 
"objects"  for  which  it  was  formed:  it  may  be  possible  to 
say  what  assets  have  been  acquired  with  that  capital,  but  even 
then  the  assets  and  the  capital  are  clearly  separate  entities. 

Then,  too,  the  profit  and  loss  account  must  obviously  be 
framed  so  as  to  show  the  divisible  profits,  and  the  question  thus 
remains  to  be  considered  how  profits  and  losses  that  do  not 
affect  revenue — or,  to  put  it  another  way,  capitalized  apprecia- 
tions and  depreciations — ^are  to  be  treated.  As  a  matter  of 
bookkeeping,  it  is  clear  that  two  courses  are  open.  Either  the 
capitalized  items  must  be  disregarded  in  the  balance  sheet  by 
mis-stating  the  value  of  an  asset  or  a  liability,  or  some  account 
must  be  raised  to  record  the  profit  or  loss  that  is  not  taken 


VALUATION    OF    FIXED    ASSETS.  I71 

to  revenue.  If  the  latter  course  be  adopted,  the  accounts 
should  be  sufficiently  clear  to  explain  what  has  been  done:  in 
the  former  case,  if  the  assets  are  over-stated  it  is  also  necessary 
that  mention  should  be  made  of  the  fact,  as  the  assets  appear- 
ing  in  the  balance  sheet  are  prima  facie  assumed  to  be  stated 
at  a  reasonable  valuation.  If,  however,  a  profit  has  been  made 
which  is  not  available  for  distribution,  it  is  often  considered 
unnecessary  to  modify  the  accounts  so  as  to  disclose  the  cir- 
cumstance. This  point,  however,  will  be  discussed  more  fully 
under  the  heading  of  Secret  Reserves.  As  a  rule,  the  amount 
at  which  all  assets  are  stated  in  the  balance  sheet  should  be 
regulated — at  all  events  to  some  extent — by  the  value  of  such 
assets. 

In  practice,  assets  may  generally  be  divided  into  two  classes : 
(i)  Those  with  which  business  is  carried  on,  and  (2)  those 
in  which  business  is  carried  on;  the  former  may  be  named 
fixed  assets,  the  latter  current  assets. 

VALUATION  OF  FIXED  ASSETS. 

The  points  to  be  borne  in  mind  here  are  that  wasting  may 
reduce  their  value,  and  that  fluctuation  may  increase  or  re- 
duce their  value.  So  far  as  wasting  is  concerned,  inasmuch 
as  it  has  directly  contributed  to  the  profit  earned,  it  is  clearly 
an  expense  with  which  profit  may  be  fairly  charged.  The 
only  question  is  "How  ?"  which  will  be  considered  in  full  under 
the  head  of  DErRECiAxiON.  On  the  other  hand,  fluctuation  is 
something  altogether  apart  from  trading  profit  and  loss,  being 
merely  the  accidental  variation  (owing  to  external  causes)  in 
the  value  of  certain  property  owned,  but  not  traded  in :  to  carry 
the  amount  of  such  variation  to  profit  and  loss  account  would 
be  to  disturb  and  obscure  the  results  of  actual  trading,  and  so 
render  comparison  difficult,  if  not  impossible.  Moreover,  as 
has  already  been  stated,  the  profit  and  loss  account  should  be 
so  framed  as  to  show  a  balance  which  actually  exists  and  is 
legally  available  for  dividends.  On  no  account,  therefore,  should 
the  results  of  fluctuations  affect  the  profit  and  loss  account. 


\*J2  AUDITING. 

Whether  or  not  it  is  desirable  that  such  fluctuations  should  be 
revealed  by  the  accounts  at  all  will  be  fully  considered  under 
the  head  of  Secret  Reserves. 

It  follows  that  the  usual  rule  for  stating  the  values  of  fixed 
assets  in  the  balance  sheet  would  be :  Cost,  less  such  an  amount 
as  is  chargeable  to  profit  and  loss  for  accrued  depreciation  or 
exhaustion  due  to  the  operations  of  the  business  for  which 
they  have  been  used. 

The  actual  cost  of  acquiring  fixed  assets  (e.  g.,  stamps,  con- 
veyances, miscellaneous  fees,  &c.)  is  usually  capitalized.  This 
is  not  unreasonable,  as  such  expenses  are  clearly  an  integral 
part  of  the  cost  price  of  such  assets. 

VALUATION  OF  CURRENT  ASSETS. 

It  being  the  essential  feature  of  these  assets  that  the  whole 
aim  of  the  undertaking  is  to  convert — or  be  able  to  convert — 
them  into  cash  at  the  earliest  possible  opportunity,  the  ele- 
ment of  immediate  realization  is  an  important  factor  in  their 
value.  The  only  point  to  remember  is  that,  while  a  manu- 
facturing profit  is  earned  only  when  the  manufacture  is  com- 
pleted, a  trading  profit  is  only  made  when  the  sale  is  effected. 
Neither  profit  must  be  anticipated,  but  it  does  not  appear  to 
be  invariably  essential  that  manufacturing  profit  should  be 
held  over  until  a  sale  has  been  effected.  It  may  be  added  that, 
where  a  manufacture  consists  of  several  distinct  processes,  and 
separate  accounts  are  kept  of  the  manufacturing  profit  earned 
under  each  process,  there  seems  to  be  no  great  objection  to 
each  process  being  considered  as  a  separate  manufacture,  so 
long,  of  course,  as  the  goods  are  readily  saleable  at  the  usual 
trading  price. 

It  must  not  be  lost  sight  of,  however,  that  these  are  book 
profits  only,  and  in  this  connection  it  is  well  to  bear  in  mind 
the  decision  in  the  American  Malting  case  (see  Appendix  C), 
where  the  court  said :  "To  calculate  months  in  advance  on  the 
result  of  the  future  transactions,  and  on  such  calculations  to 


RESPONSIBILITY  FOR  VALUES.  173 

declare  dividends,  was  to  base  such  dividends  on  paper  profits 
— hoped  for  profits,  future  profits — and  not  upon  the  surplus 
or  net  profits  required  by  law." 

With  regard  to  what  is  a  trading  profit,  a  most  ingenious 
argument  was  once  advanced  by  counsel  who  subsequently 
became  Lord  Chief  Justice  of  England,  who  contended  that 
the  most  scientifically  correct  method  of  valuing  a  stock-in- 
trade  was  to  take  it  at  selling  prices,  less  the  average  trade 
profit;  it  being  suggested  that  any  profit  realized  in  excess  of 
the  average  was  in  reality  a  profit  on  buying,  not  on  selling; 
and  any  profit  realized  less  than  the  average,  a  corresponding 
loss  on  buying.  The  argument  passed  muster  at  the  time, 
appears  to  be  plausible,  and  indicates  a  system  that  would 
doubtless  prove  very  convenient  in  practice;  but,  unless  the 
profit  on  different  articles  was  very  uniform,  it  would  hardly 
be  a  safe  one  to  adopt. 


RESPONSIBILITY  FOR  VALUES. 

A  much-debated  point  is  the  extent  of  responsibility  in- 
curred by  the  auditor  in  relation  to  the  values  set  upon  the 
assets  of  a  company  in  the  published  accounts  of  the  directors. 
The  opinion  arrived  at  in  the  English  Court  of  Appeal  in  The 
London  and  General  Bank  case  upon  this  most  important  point 
appears  to  be  that  the  auditor  incurs  no  responsibility  what- 
ever so  long  as,  after  exercising  reasonable  care  and  diligence, 
he  has  honestly  arrived  at  the  opinion  that  the  accounts  are 
correct.  It  will  be  seen,  however,  that  this  decision  in  no  way 
commits  itself  to  the  expression  of  any  particular  opinion  as 
to  the  mode  of  valuation  to  be  adopted.  In  this  latter  respect 
it  is  interesting  to  note  a  recommendation  by  a  Committee  of 
the  Englisli  Board  of  Trade  that  the  balance  sheet  of  every 
company  shall  show  {inter  alia)  ''whether  the  assets  are  taken 
at  cost  price,  or  by  valuation,  or  on  what  other  basis 
they  are  stated,  and  whether  any,  and  if  so  what,  amount  or 
percentage,  has  been  written  off,  and  what  other  provision,  if 


174  AUDITING. 

any,  has  been  made  for  depreciation."  This  recommendation 
is  a  very  excellent  practice  to  follow,  and  has  for  many  years 
past  been  adopted  by  some  leading  accountants. 

The  question  of  auditorial  responsibility  is  fully  considered 
in  Chapter  X. 


VERIFYING  EXISTENCE  OF  ASSETS. 

Having  settled  a  basis  of  valuation,  the  next  thing  would 
appear  to  be  to  obtain  evidence  of  the  existence  of  the  assets 
enumerated  in  the  balance  sheet. 

The  evidence  necessary  in  each  class  of  assets  would  be  as 
follows : — 

LAND  AND  BUILDINGS.— The  title  deeds  of  the  prop- 
erty should  be  and  sometimes  are  sufficient  evidence,  but  it  is 
to  be  regretted  that  title  deeds  are  not  always  delivered/  in 
real  estate  transfers.  Where  there  is  any  doubt  upon  this 
point  the  official  county  records  should  be  consulted.  Should 
the  property  be  mortgaged  the  title  deeds  may  possibly  be  in 
the  possession  of  the  mortgagee  (although  this  practice  does 
not,  so  far  as  is  known,  exist  in  the  United  States),  and  in  such 
a  case  an  acknowledgment  of  this  fact  should  be  obtained 
from  him  or  his  attorney,  together  with  a  statement  of  the 
amount  due.  Conversely,  the  verification  of  an  asset  repre- 
sented by  a  mortgage  would  be  the  production  of  the  title 
deeds  and  the  mortgage  papers.  In  the  case  of  a  second  mort- 
gage, the  title  deeds  may,  as  stated  above,  be  in  the  custody 
of  the  first  mortgagee,  and  here  the  auditor  will  require  to 
satisfy  himself  that  such  first  mortgagee  has  received  proper 
notice  of  the  existence  of  a  second  charge. 

STOCKl-IN-TRADE,— The  original  stock  sheets,  signed 
by  the  stock-taker,  calculator,  checker,  and  manager.  Most 
accountants  would,  in  addition,  consider  it  essential  that  the 
extensions  and  additions  be  re-checked  by  one  of  their  own 


VERIFYING  EXISTENCE  OF  ASSETS.  1 75 

Staff,  and,  further,  require  to  be  satisfied  as  to  the  soundness 
of  the  principle  of  valuation  adopted. 

The  auditor's  liability  in  connection  with  the  valuation 
placed  in  the  accounts  upon  the  amount  of  stock-in-trade  has 
been  considered  in  several  English  cases,  which  are  more  fully 
dealt  with  in  Chapter  X.  It  may  be  pointed  out  at  this  -stage, 
however,  that  the  general  effect  of  these  decisions  seems  to 
be  that,  where  the  circumstances  of  the  case  are  not  such  as 
to  arouse  the  suspicions  of  an  ordinarily  capable  and  diligent 
auditor,  he  is  justified  in  relying  upon  the  valuation  of  stock- 
in-trade  which  has  been  submitted  to  him  and  certified  to  him 
by  the  manager.  It  is  altogether  likely  that  American  de- 
cisions will  follow  this  general  rule.  In  one  English  case, 
the  auditors  took  the  precaution  to  state  in  their  certificate  that 
they  accepted  no  responsibility  for  the  valuation  of  the  stock 
"which  had  been  certified  to  them  by  the  managing  director," 
and  as  a  matter  of  prudence  it  would  no  doubt  be  as  well  for 
the  auditors  to  always  add  this  qualification.  It  may  be  added, 
however,  that  such  a  qualification  as  this  would  certainly  not 
appear  to  save  the  auditor,  where  he  had  reasonable  grounds 
for  doubting  the  valuation  itself ;  whenever  his  suspicions  have 
been  aroused,  it  is  absolutely  necessary  that  the  auditor  should 
sift  the  matter  to  the  bottom. 

INVESTMENTS  IN  STOCKS  AND  BONDS.— The 
auditor  will  require  to  have  produced  to  him  the  scrip,  certi- 
ficate, bond,  or  other  document,  proving  that  the  ownership 
of  the  investment  in  question  is  vested  in  his  clients;  and  he 
should  also  require  production  of  the  broker's  bill,  with  a  view 
to  verifying  the  cost  price  thereof. 

In  the  case  of  securities  deposited  under  reorganization 
plans,  &c.,  it  becomes  necessary  to  secure  a  certificate  that, 
upon  the  date  of  the  accounts,  such  stock  or  bonds  stood 
registered  in  the  names  of  the  auditor's  clients.  Of  course, 
if  a  negotiable  receipt  has  been  given,  the  receipt  itself  must 
be  produced,  but  if  it  is  a  mere  memorandum  receipt,  the  date 


176  AUDITING. 

must  be  carefully  noted,  as  it  may  be  that  in  the  event  of  a 
subsequent  sale  it  does  not  have  to  be  surrendered. 

Funds  deposited  as  security  should  be  verified  by  an  in- 
dependent confirmation  addressed  to  the  auditor. 

Investments  on  behalf  of  a  company  sometimes  stand  in  the 
names  of  individuals,  who  hold  them  in  trust  for  the  company. 
A  proper  declaration  of  trust,  duly  executed,  should  in  all 
cases  be  produced  to  the  auditor. 

It  may  be  added  that  if,  when  examined,  the  securities  are 
securely  sealed  up  in  packages,  it  is  not  necessary  at  subse- 
quent audits  to  re-examine  them  in  detail,  if  the  seals  remain 
unbroken. 

BOOK  DEBTS.— The  extent  to  which  it  is  practicable  to 
verify  the  existence  of  book  debts  depends  largely  upon  cir- 
cumsstances.  Unless  ^they  are  very  numerous,  the  auditor 
should  satisfy  himself  that  the  total  appearing  in  the  balance 
sheet  agrees  with  the  ledger  balances,  and  that  proper  pro- 
vision has  been  made  for  cash  discounts  and  bad  debts.  With 
regard  to  the  discounts,  it  is  customary  to  deduct  the  full  cash 
discount  upon  all  ledger  balances.  It  is  questionable  whether 
this  is  really  necessary,  although  it  is  clearly  a  prudent  course 
to  adopt;  but  where  cash  discounts  are  deducted  from  the 
trade  creditors  they  must,  of  course,  be  also  deducted  from  the 
trade  debtors.  With  regard  to  bad  debts,  the  auditor  should 
obtain  a  certificate  of  at  least  one  responsible  person  ac- 
quainted with  the  facts,  to  the  effect  that  in  his  judgment  due 
provision  has  been  made  for  any  loss  that  is  reasonably  likely 
to  occur.  It  is  naturally  impossible  for  the  auditor  to  verify 
this  provision  in  detail,  but  he  can  at  least  take  note  of  overdue 
and  "dead"  accounts,  and  see  whether  such  provision  as  ap- 
pears to  him  to  be  adequate  has  been  made  in  respect  of  these. 
As  the  number  of  book  debts  increases  it  becomes  imprac- 
ticable for  the  auditor  to  verify  the  ledger  balances  in  de- 
tail; it  has  already  been  explained,  however,  that,  where  an 


OP  THE 

UNIVERSITY/ 

OF 

VERIFYING   EXISTENCE   OF   ASSETS.  I77 

adequate  system  of  internal  check  exists,  the  verification  of 
details  can  to  a  large  extent  be  superseded  by  tests.  For  all 
practical  purposes  it  is  probably  as  efficacious  to  check  the 
balances  of,  say,  one  or  two  ledgers  out  of  twenty  as  it  would 
be  to  check  the  whole. 

PLANT,  MACHINERY,  FIXTURES,  &c.— There  is, 
perhaps,  too  much  tendency  to  assume  the  correctness  of  the 
"book"  figures  with  regard  to  these  assets,  provided  reason- 
able provision  has  been  made  for  depreciation :  it  is  important, 
however,  to  make  careful  inquiries  into  all  additions,  with  a 
view  to  seeing  that  they  represent  bona  fide  capital  expendi- 
ture that  may  properly  be  added  to  the  value  of  the  asset,  and, 
further,  to  make  particular  inquiry  as  to  the  sale  of  worn-out 
or  discarded  assets.  It  not  infrequently  happens  that  such 
sales  are  erroneously  credited  to  sales  account,  with  the  re- 
sult that  the  latter  is  overstated,  and  that  due  inquiry  into  the 
loss  in  respect  of  such  sales  is  overlooked.  The  amount  real- 
ized on  the  sale  of  fixed  assets  should,  of  course,  be  credited 
to  the  real  account  standing  in  the  books  in  respect  of  this 
asset;  but  the  realization  affords  an  opportunity  of  inquiring 
into  the  value  at  which  these  assets  stood  in  the  books,  and 
should  they  have  been  sold  at  a  loss,  that  loss  must  in  all  cases 
be  written  off,  as  otherwise  an  item  will  be  brought  into  the 
balance  sheet  as  an  asset  which  represents  assets  no  longer  in 
existence. 

Occasionally,  as  has  already  been  stated,  a  re-valuation  will 
be  made  for  the  purpose  of  assessing,  or  of  checking,  the  pro- 
vision for  depreciation ;  but  in  any  case  a  certificate  should  be 
forthcoming,  to  the  effect  that  the  various  items  included  in 
the  last  inventory  are  still  the  property  of  the  undertaking. 

BANK  BALANCE.— Bank  pass  book  verified  either  by 
personal  visit  to  bank  or  by  banker's  certificate  of  balance. 

In  practice  it  will  rarely  happen  that  the  balance  recorded 
in  the  pass  book  exactly  agrees  with  the  balance  in  the  stub. 


178  AUDITING. 

and  a  Reconciliation  Account  has  therefore  to  be  prepared 
upon  the  following  lines : — 


Balance  as  per  stub 

$6,033.08 

Add,  Cheques  unpaid,  viz. : — 

Dec.  16,  Jones 

$140. 

,20 

"     21,  Smith 

89 

.29 

'*     29,  Brown 

362 

.  12 

591.61 

Less,  Deposits,  not  credited,  viz. : — 

$6,624.69 

Dec.  30,  Collection 

$600 

.00 

"     31,  Sundries 

212 

•50 

812.50 

Balance  as  per  pass  book,  Dec.  29 

$5,812.19 

Where  practicable  it  is  desirable  that  the  auditor  should 
see  that  the  various  adjustments  which  constitute  the  differ- 
ence between  the  pass  book  balance  and  the  cash  book  bal- 
ance are  rectified  in  due  course  by  subsequent  entries  in  the 
pass  book. 

CASH  IN  HAND. — Verified  by  production  of  actual  cash 
balance,  or,  if  the  date  of  the  accounts  has  gone  by,  by  ex- 
haustively verifying  the  bank  account  up  to  date  of  audit  and 
then  counting  the  balance  of  cash  in  hand.  In  cases  where 
there  is  more  than  one  cash  drawer,  all  must  be  produced  to 
the  auditor  and  verified  by  him  simultaneously ;  and,  wherever 
practicable,  it  is  preferable  that  all  cash  in  hand  should  be 
paid  into  the  bank  on  the  afternoon  of  the  date  of  the  balance 
sheet,  in  which  case,  of  course,  no  occasion  arises  for  the  audi- 
tor to  verify  the  balance  of  cash  in  hand,  for  the  all-sufficient 
reason  that  there  is  none.  In  the  case  of  cash  at  distant 
branches,  a  satisfactory  certificate  that  the  balance  exists  may 
generally  be  accepted  in  lieu  of  actual  counting.  In  contin- 
uous audits  all  cash  balances  should  be  frequently  verified,  say,, 
at  least  once  a  month. 

Whatever  may  be  said  in  general  terms,  however,  as  to  the 
desirability  of  an  auditor  verifying  balances  of  cash  in  hand,  it 
is  clear  that  it  would  be  only  prudent  to  regard  the  existence 


VERIFYING  EXISTENCE   OF   ASSETS.  I79 

of  a  large  floating  balance  as  prima  facie  a  matter  for  sus- 
picion, and  therefore  a  matter  calling  for  careful  inquiry. 

BILLS  RECEIVABLE.— Verified  by  production  of  the 
actual  notes  themselves.  Care  should  be  taken  to  see  that  no 
overdue  notes  are  included  in  a  balance  sheet  under  the  head- 
ing of  "Bills  Receivable";  that  due  provision  is  made  for  dis- 
count where  necessary ;  and  that  all  anticipated  loss  by  way  of 
bad  debts  in  respect  of  bills  receivable — both  in  hand  and  under 
discount — is  included  in  the  accounts. 

WORK  IN  PROGRESS.— This  should  be  certified  by  the 
factory  manager,  the  chief  cost  clerk  and  the  manager.  In 
the  case  of  readily  saleable  goods  manufactured  in  quantities, 
the  usual  rule  is  to  value  work  in  progress  at  cost — the  term 
"  cost "  being  defined  as  the  cost  shown  by  the  cost  accounts, 
which,  as  a  rule,  includes  of  course,  a  certain  amount  of 
"  loading "  for  factory  and  overhead  expenses.  When  the 
work  of  any  one  manufacturing  department  has  been  com- 
pleted, there  seems  no  reason  why  that  department  should  not 
be  entitled  to  take  full  credit  for  the  entire  cost  of  the  work 
performed,  and  in  such  case  care  must  be  taken  to  see  that 
the  stock  of  unfinished  goods  represents  items  that  will  be 
finished  and  sold  at  the -normal  rate  in  due  course. 

When  work  in  progress  consists  of  single  articles — as,  for 
example,  in  the  case  of  contract  work — its  valuation  becomes 
both  a  more  difficult  and  a  more  serious  matter,  partly  because 
past  experience  is  no  longer  available  as  a  guide  and  partly 
on  account  of  the  magnitude  of  the  figures  involved.  In  the 
case  of  contracts  extending  over  a  number  of  years,  it  is  clear 
that  annual  accounts  can  only  approximately  estimate  the  true 
net  profit  earned  in  each  year.  In  the  case  of  manufacturing 
firms  it  is  for  the  partners  to  mutually  agree  on  a  basis  for 
the  valuation  of  work  in  progress,  but  the  safest  course  would 
appear  to  be  not  to  take  credit  for  any  profit  on  uncompleted 
work.  In  the  case  of  companies,  however,  which  require  to 
produce  annual  accounts,  and  to  pay  annual  dividends,  this 
course  is  hardly  practicable.     A  company  is  not  obliged  to 


l8o  AUDITING. 

wait  until  profits  have  been  actually  realized  in  cash  before 
crediting  anything  to  revenue.  There  is,  therefore  no  illegality 
in  taking  credit  for  estimated  profit  on  work  in  progress ;  but, 
in  view  of  the  extreme  difficulty  of  arriving  at  an  accurate 
estimate,  and  the  extreme  uncertainty  that  often  prevails  as  to 
what  the  ultimate  result  will  be,  it  is  clear  that  only  very  con- 
servative estimates  can  be  safely  indulged  in.  Here,  again, 
the  principle  laid  down  in  the  American  Malting  case  should  be 
emphasized,  and  care  taken  to  keep  within  the  rule  that  divi- 
dends must  not  be  paid  out  of  anticipated  profits.  Cost  ac- 
counts should,  of  course,  in  all  cases  be  available  to  show  the 
actual  cost  of  each  contract  up  to  the  date  of  the  accounts.  If 
the  work  has  so  far  proceeded  that  it  is  possible  for  the  Man- 
ager to  certify  an  outside  figure,  that  will  not  be  exceeded,  for 
the  cost  of  completing  the  work,  it  would  not  be  unreasonable 
to  apportion  the  profit  between  the  two  periods  according  to 
the  expenditure  incurred  in  each,  providing,  of  course,  ample 
reserves  in  all  doubtful  cases.  In  connection  with  work  less 
far  advanced  it  seems  more  questionable  whether  anything  in 
excess  of  manufacturing  cost  can  be  safely  treated  as  an  asset. 
In  this  connection,  however,  it  may  be  borne  in  mind  that  all 
large  contracts  are  readily  capable  of  division  into  sections, 
the  cost  of  each  of  which  has  already  been  estimated  in  ad- 
vance. A  comparison  of  the  cost  accounts  in  respect  of  the 
work  performed  with  the  original  estimates  will  thus  enable 
a  fairly  reliable  view  to  be  obtained  of  the  general  position 
of  the  contract,  more  especially,  of  course,  in  those  cases 
where  the  speculative  part  of  the  work  is  in  the  earlier  stages. 

In  the  majority  of  cases,  where  contracts  extend  over  a 
lengthy  period,  it  is  usual  for  payments  to  be  made  on  account, 
upon  the  certificate  of  the  architect,  or  engineer,  as  the  case 
may  be.  The  amount  of  such  payments  would  be  from 
seventy-five  per  cent,  to  ninety  per  cent,  of  the  value  of  the 
work  actually  performed,  and  it  is  clear,  therefore,  that  the 
excess  of  money  received  over  expenditure  incurred  may  safely 
be  regarded  as  the  minimum  profit  earned  up  to  date. 


SALES  FOR  FUTURE  DELIVERY.  l8l 

SALES  FOR  FUTURE  DELIVERY. 

The  question  has  arisen  more  than  once  as  to  whether  a 
company  is  entitled  to  take  credit  for  profit  expected  to  be 
earned  in  respect  of  orders  booked  for  future  delivery.  The 
point  is  naturally  one  of  considerable  importance  in  some  in- 
dustries, as,  for  example,  with  automobile  dealers,  who  fre- 
quently book  orders  for  future  delivery,  and  also  with  regard 
to  coal  merchants,  cotton  merchants,  and  the  like,  who  enter 
into  contracts  to  supply  their  goods  for  some  time  in  advance. 
The  general  rule  which  has  been  laid  down  in  this  work  is, 
it  is  thought,  unquestionably  the  safe  one  to  in  all  cases  adhere 
to,  namely,  that  the  profit  on  the  sale  of  goods  should  be  taken 
credit  for  at  the  time  when  the  sale  actually  occurs ;  and  where 
it  is  an  essential  portion  of  the  contract  of  sale  that  the  goods 
shall  not  be  delivered  until  some  future  date,  then  the  actual 
sale  would  certainly  appear  to  be  at  the  date  of  delivery,  and 
not  at  the  date  of  booking  the  order.  Like  many  other  mat- 
ters, however,  this  is,  perhaps,  as  much  a  matter  of  degree  as 
a  question  of  principle,  and  where  orders  have  been  actually 
booked  so  that  a  valid  contract  exists  upon  which  the  customer 
could  be  sued  for  payment,  the  mere  fact  that  the  goods  have 
not  been  delivered  might  well  be  overlooked  and  the  profit 
taken  credit  for  in  the  period  when  the  order  was  booked; 
this,  however,  could  certainly  only  be  applied  where  the  goods 
were  actually  in  stock,  and  not  when  they  were  still  unmade. 
Even  where  it  is  decided  that  credit  may  reasonably  be  taken 
for  such  future  sales,  it  is  important  to  remember  that  when 
payment  is  delayed  a  reasonable  rebate  should  be  made  for  loss 
of  interest,  and  under  no  circumstances  could  any  harm  be  done 
by  postponing  the  whole  of  the  profit  until  the  period  when 
the  goods  were  actually  delivered. 

The  American  Malting  decision  has  been  handed  down  since 
the  above  was  written,  and  in  view  of  the  opinions  there  ex- 
pressed it  may  be  assumed  that,  from  a  legal  point  of  view, 
considerable  risk  is  taken  whenever  anticipated  profits  are  car- 
ried into  the  books. 


1 82  AUDITING. 

OUTSTANDING  ASSETS. 

The  point  that  now  claims  attention  is  the  question  as  to 
how  far  it  is  the  auditor's  duty  to  consider  the  propriety  of 
including  certain  items  among  the  assets  that  relate  to  trans- 
actions which  at  the  date  of  the  balance  sheet  are  uncom- 
pleted. 

It  has  been  said  that  no  profits  should  be  taken  into  account 
that  have  not  been  actually  received  in  cash,  unless  there  is 
every  reasonable  likelihood  that  they  will  eventually  be  so  re- 
ceived. This,  of  course,  means  that  a  sufficient  provision  must 
always  be  made  for  bad  and  doubtful  debts,  but  it  means  some- 
thing else  besides.  With  some  classes  of  transactions  it  is  quite 
possible — even  though  the  transactions  themselves  are  not  ac- 
tually completed — to  say  with  reasonable  certainty  what  profit 
will  eventually  result ;  and,  in  these  cases,  it  would  appear  that 
the  most  correct  course  would  be  to  apportion  the  profit  so 
that  each  period  took  credit  for  the  profit  arising  from  its 
portion  of  the  transaction.  Thus,  in  the  absence  of  evidence 
that  would  lead  one  to  a  contrary  supposition,  the  profit  arising 
from  sales  may  safely  be  credited  to  the  period  in  which  the 
sales  occur,  and  the  profit  arising  from  manufacture  similarly 
belongs  to  the  period  in  which  the  articles  are  manufactured. 
The  income  arising  from  first-class  investments  (e.  g.,  interest 
on  government  or  railway  bonds,  or  interest  on  mortgages,  or 
rents)  may  likewise  be  said  to  accumulate  from  day  to  day. 
With  regard  to  the  latter,  however,  the  question  of  convenience 
intervenes;  and,  unless  the  amount  involved  is  of  sufficient 
magnitude  to  render  absolute  accuracy  desirable,  it  would  prob- 
ably be  considered  sufficient  if  only  those  sums  actually  due 
were  considered  as  assets — the  amount  accruing  being  taken  as 
a  set-off  against  liabilities  of  a  similar  nature.  Turning  now 
to  another  class  of  transactions,  the  final  result  of  which  can 
only  be  approximately  determined,  no  accruing  profit  can,  with 
safety,  be  taken  credit  for  upon  the  uncompleted  voyages  of 
ships,  or  uncompleted  contracts  (except  so  far  as  previously 
indicated),  nor  for  accruing  dividends  other  than  on  guar- 


OUTSTANDING   LIABILITIES.  1 83 

anteed  stock,  nor  (under  normal  circumstances)  for  uncom- 
pleted consignments;  the  eventual  result  of  all  these  transac- 
tions being  generally  of  so  speculative  a  nature  that  it  is  not 
safe  to  do  more  than  carry  forward  whatever  expenses  may 
have  been  incurred. 

Sometimes,  for  the  purpose  of  providing  a  secret  reserve, 
assets  are  intentionally  understated;  except  when  done  advis- 
edly, however,  there  is  but  little  fear  of  the  auditor  finding 
the  assets  understated.  Occasionally  defalcations  have,  by  this 
means,  been  made  to  fall  upon  revenue  (generally  by  writing 
off  good  debts  as  bad),  but  the  attention  thereby  attracted 
to  the  existence  of  a  leakage  prevents  such  a  course  from  being 
at  all  common. 

OUTSTANDING  LIABILITIES. 

For  a  similar  reason,  there  is  but  little  fear  of  liabilities 
being  overstated;  how  far  it  is  necessary  for  the  auditor  to 
take  special  steps  to  guard  against  their  under-statement  is 
the  matter  that  now  claims  attention.  While  the  practice  of 
"  dating-forward  "  invoices  is  so  common,  there  will  always 
be  some  danger  of  goods  being  included  in  stock  without  hav- 
ing been  passed  to  the  credit  of  the  purchase  ledger.  "  Stock- 
taking "  statements  might  help  to  discover  the  omission,  but 
they  also  might  not.  It  will  be  a  great  help,  therefore,  if  the 
services  of  the  stock-keeper  are  requisitioned,  and  he  be  made 
responsible  for  the  production  of  invoices  for  all  goods  that 
have  passed  through  his  hands.  The  purchases  for  the  next 
few  weeks  after  the  date  of  balancing  may  also  be  usefully 
scrutinized. 

All  expense  accounts  (e.  g.,  wages,  salaries,  &c.)  should 
be  carefully  examined,  to  make  sure — as  far  as  possible — that 
no  outstanding  liabilities  have  been  omitted. 

It  is  a  common  practice  to  set  off  accruing  rent,  interest, 
&c.,  against  insurance,  taxes,  and  other  items  paid  in  advance, 
.and  to  keep  a  fixed  sum  suspended  to  meet  whatever  difference 


184  AUDITING. 

there  may  be.  The  plan  certainly  possesses  the  advantage  of 
convenience,  combined  with  practical  accuracy;  but  the  suffi- 
ciency of  the  fixed  sum  should  be  verified  at  every  audit,  as  the 
circumstances  may  easily  vary  from  time  to  time. 

The  auditor's  own  fee  is  a  matter  in  which  he  will  naturally 
be  interested.  There  is  no  uniform  practice,  however,  some 
preferring  to  debit  the  accounts  of  the  period  under  audit  with 
the  fee,  and  some  the  period  in  which  the  audit  is  conducted. 
The  latter  course  is  naturally  the  most  convenient  where  the 
amount  chargeable  depends  upon  the  time  occupied,  but  the 
former  method  is  probably  the  more  correct. 

The  minute  book  may,  and  frequently  does,  disclose  the 
existence  of  liabiHties — both  certain  and  contingent — that  are 
not  recorded  in  the  books  of  account,  and  an  audit  cannot  be 
called  complete  unless  this  book  is  carefully  scanned.  A  case 
in  point  occurred  in  connection  w^th  the  audit  of  a  street  rail- 
way company  where  the  minutes  stated  that  the  President  was 
to  receive  his  salary  in  common  stock  at  par.  As  a  matter  of 
fact,  he  had  been  drawing  it  in  cash,  but  as  the  stock  was  worth 
only  a  few  dollars  a  share  the  variation  made  a  material  differ- 
ence to  the  company. 

CONTINGENT  LIABILITIES  must  not  be  forgotten. 
Bills  discounted  are,  perhaps,  the  most  usual  source  of  contin- 
gent liability;  a  reserve  therefor  rarely  appears  in  a  balance 
sheet,  however,  although  frequent  losses  occur  through  the 
failure  of  makers  to  pay  their  notes.  The  auditor  should, 
therefore,  scrutinize  the  notes  under  discount,  and  particular 
attention  should  be  paid  to  those  which  have  been  renewed 
one  or  more  times  without  any  reduction  being  made  in  the 
amount.  Disputed  claims  must  not  be  lost  sight  of ;  and 
claims  for  dilapidations  upon  premises,  the  lease  of  which  has 
almost  expired,  should  be  anticipated,  so  that  the  whole  loss 
may  not  fall  upon  one  year. 

It  is  sometimes  claimed  that  arrears  of  cumulative  preferred 
dividends  also  come  under  this  heading,  but  this  can  hardly 


HIRE-PURCHASE    AGREEMENTS.  185 

be  admitted.  Such  dividends  are  under  no  circumstances  a 
liability — definite  or  contingent — until  declared,  and  any  arrears 
are  only  of  interest  as  to  future  distributions  of  profits  between 
preferred  and  common  stockholders.  Hence,  a  simple  foot 
note  on  the  balance  sheet  of  the  amount  in  arrears  would 
cover  the  case. 


HIRE-PURCHASE  AGREEMENTS. 

This  subject  is  of  sufficient  importance  to  merit  a  separate 
heading.  Detailed  treatment  of  the  subject  may  be  found  in 
the  author's  "  Advanced  Accounting,"  which  deals  fully  with 
those  advanced  problems  that  are  questions  of  account,  as 
such,  rather  than  questions  of  auditing. 

From  the  auditor's  point  of  view,  the  main  point  of  im- 
portance is  to  see  that  a  correct  system  of  dealing  with  the 
transactions  is  adopted  which  charges  a  sufficient  proportion 
of  the  instalments  against  the  revenue  of  each  year,  so  as  to 
avoid  the  proportion  which  is  being  capitalized  appearing  at 
too  high  a  figure. 

There  is  some  difference  of  opinion  as  to  the  proper  method 
of  treating  railroad  car  trust  bonds  which  represent  a  species 
of  hire-purchase  agreement.  One  opinion  is  that  entries  per- 
taining to  car  trusts  need  only  be  made  in  the  books  of  the 
lessee-purchaser  as  payments  provided  for  in  the  agreement 
are  made,  and  consequently  no  liability  need  be  shown  in  the 
balance  sheet  for  the  instalments  not  yet  due.  As  a  matter  of 
fact  this  course  is  followed  by  some  of  the  largest  railroads  in 
the  United  States.  The  President's  report  of  one  of  them  for 
1908  shows  that  at  December  31  of  that  year  the  Company  had 
outstanding  for  account  of  itself  and  its  sub-companies  car- 
trust  certificates  aggregating  some  $61,000,000.00,  which,  with 
the  exception  of  a  comparatively  small  amount  (presumably 
the  proportion  of  the  next  instalment  accrued  to  December  31) 
do  not  appear  in  the  balance  sheet  at  all. 


1 86  AUDITING. 

It  is  submitted  that  this  is  a  very  unsatisfactory  method  of 
treating  such  transactions.  Certainly  these  car-trust  certificates 
are  just  as  real  a  liability  as  any  of  the  mortgage  bonds,  and 
usually  they  run  for  much  shorter  periods.  It  may  be  con- 
tended that  the  equipment,  which  is  the  subject  of  these  certifi- 
cates, is  not  the  property  of  the  railroad  company  and  will  not 
be  until  fully  paid  for,  and  hence  it  would  not  be  proper  to 
include  it  among  the  assets  of  the  company.  This  objection 
is  hardly  a  logical  one,  as  it  would  be  just  as  valid  against 
including  assets  which  are  specifically  pledged,  or  conveyed  in 
trust,  to  secure  an  issue  of  mortgage  bonds,  and  it  is  hardly 
thought  that  any  one  would  argue  for  excluding  mortgage 
bonds  and  the  property  securing  the  same  from  the  balance 
sheet.  The  best  method  of  treating  such  obligations  from  an 
accounting  standpoint  is  to  enter  them  as  a  liability  when  con- 
tracted, the  equipment  covered  thereby  being  treated  as  an 
asset ;  if  it  is  desired,  a  separate  account  can  be  kept  for  such 
equipment  as  well  as  showing  it  separately  in  the  balance  sheet. 

Cases  frequently  occur  in  which  furniture,  musical  instru- 
ments, books,  &c.,  are  sold  under  hire-purchase  agreements, 
and  in  these  cases  the  rate  of  interest  charged  is  almost  invari- 
ably high,  usually  varying  from  ten  per  cent,  to  thirty  per 
cent,  per  annum  on  the  unpaid  instalments.  For  present  pur- 
poses it  will  be  sufficient  to  point  out  that  firms  transacting 
business  of  this  description  in  the  nature  of  things  deal  with  a 
very  large  number  of  items,  each  of  comparatively  small 
amount.  It  consequently  follows  (i)  that  it  is  impracticable 
to  keep  such  intricate  accounts  as  would  be  necessary  to  accu- 
rately apportion  every  instalment  received  between  interest  and 
capital;  (2)  that  such  scrupulous  exactness  is  unnecessary  in 
practice,  as  the  volume  of  the  transactions  is  sufficient  to  en- 
able an  average  to  produce  fairly  reliable  results.  The  best 
principle,  therefore,  is  to  regard  the  difference  between  the 
cash  price  and  the  credit  price  of  the  articles  sold  as  interest 
charged,  and  having  ascertained  the  average  rate  of  interest 
to  apportion  it  between  the  years  over  which  the  currency  of 


DEPRECIATION.  1 8/ 

these  agreements  runs.  By  this  means  practically  accurate 
results  can  be  obtained  with  a  very  small  expenditure  of  labor. 
The  apportionment  should,  however,  be  in  favor  of  the  later 
years,  so  as  to  err  upon  the  side  of  caution,  and  it  may  be  added 
that  the  provision  for  bad  debts  will  here  require  special  con- 
sideration. 

DEPRECIATION. 

This  is  a  question  of  the  utmost  importance,  and  it  is  there- 
fore desirable  that  the  matter  should  be  considered  in  detail. 
Before  doing  so,  however,  it  may  be  well  to  remind  the  reader 
of  the  distinction  between  depreciation  and  fluctuation.  De- 
preciation is  a  shrinkage  in  value  which,  in  the  ordinary  course 
of  events,  may  be  expected  to  take  place,  as  being  a  necessary 
consequence  of  the  possession  and  use  of  the  asset;  it  conse- 
quently is  a  charge  against  revenue.  Fluctuation,  on  the  other 
hand,  arises  from  causes  entirely  outside  the  scope  of  the  busi- 
ness, and  may  affect  the  value  of  its  assets  either  adversely  or 
favorably.  The  operations  of  fluctuation  cannot,  however, 
affect  true  trading  profits  either  one  way  or  the  other,  and,  as 
a  rule,  therefore,  it  is  best  to  disregard  it  in  the  accounts.  A 
favorable  fluctuation  in  the  value  of  fixed  assets  seems  the 
proper  subject  for  a  secret  reserve.  A  favorable  fluctuation  in 
current  assets  is  temporarily  a  secret  reserve,  which  will  be  in- 
cluded in  the  trading  profits  when  those  assets  are  realized. 
An  unfavorable  fluctuation  in  current  assets  may  be  disre- 
garded so  long  as  there  is  every  reason  to  believe  that  it  is  of 
a  temporary  character,  but  if  it  seems  likely  that  conditions  will 
remain  unfavorable  until  the  time  comes  for  realizing  those 
assets,  then  the  loss  should  be  anticipated;  or,  to  speak  more 
accurately,  it  should  be  charged  against  the  period  in  which  it 
actually  occurred,  rather  than  against  the  period  in  which  it 
was  realized.  An  unfavorable  fluctuation  in  fixed  assets  need 
not,  under  normal  circumstances,  be  charged  against  revenue 
before  declaring  dividends  out  of  current  profits.  It  may 
therefore,  be  disregarded  in  the  accounts;  but,  in  order  that 
the  true  position  of  affairs  may  be  placed  before  the  stock- 


1 88  AUDITING. 

holders,  it  is  desirable  that  either  a  note  should  be  appended  to 
the  balance  sheet,  drawing  attention  to  the  shrinkage  in  value, 
or  a  paragraph  to  that  effect  be  inserted  in  the  auditor's  report. 

In  connection  with  this  distinction  between  depreciation  and 
fluctuation  it  should  be  added  that  in  some  quarters  the  prac- 
tice has  been  strongly  advocated  of  occasionally  having  fixed 
assets  re-valued  as  a  check  upon  the  annual  provision  for  de- 
preciation, and  appraisal  companies  which  make  a  specialty  of 
valuations,  particularly  for  the  purpose  of  testing  the  adequacy 
of  insurance  carried,  have  met  with  considerable  success  in 
recent  years.  There  is  much  to  be  said  in  favor  of  re-valua- 
tions, in  that  it  is  always  desirable  to  take  every  reasonable 
opportunity  of  testing  the  sufficiency  of  estimated  provisions; 
but,  on  the  other  hand,  it  must  be  borne  in  mind  that  a  re- 
valuation can  hardly  fail  to  take  into  consideration  fluctuation 
as  well  as  depreciation,  and  consequently  may  introduce  into 
the  accounts  a  disturbing  element,  obscuring  the  real  result  of 
the  trading.  It  ought  not,  however,  to  be  impossible  to  check 
the  provision  made  for  depreciation  by  means  of  re-valuation 
without  introducing  these  complications. 

In  order  to  make  it  quite  clear  what  is  intended,  it  may  be 
pointed  out  that  a  machine  costing  (say)  $500,  and  a  further 
$100  to  repair,  may  answer  its  purpose  for  (say)  six  years, 
and  then  have  to  be  sold  as  second-hand  for  $75.  This  leaves 
a  cost  of  $525  to  be  written  off  over  the  six  years'  life.  Under 
the  circumstances  it  might  be  reasonable  to  charge  this  at  the 
rate  of  $87.50  per  annum  (equals  14^4  per  cent.),  or  the  effi- 
ciency of  the  machine  may  be  so  high  when  new  that  the  rea- 
sonable procedure  would  be  to  charge  27^  per  cent,  on  the 
reducing  balance,  which  would  reduce  the  $600  to  (approxi- 
mately) $75  at  the  end  of  the  sixth  year;  but,  whichever 
method  be  adopted,  it  is  more  than  probable  that  the  balance 
shown  on  the  machinery  account  at  the  end  of  the  first,  second, 
third,  fourth  and  fifth  years  would  not  agree  with  the  valuation 
made  by  an  expert  at  those  times.  The  reason  for  this  is  that 
the  expert  would  take  into  consideration  the  value  of  the  ma- 


DEPRECIATION. 


189 


chine  in  the  market,  whereas  the  manufacturer  is  only  con- 
cerned with  its  value  to  him.  Moreover,  the  market  value  may 
be  influenced  by  other  considerations  besides  the  actual  condi- 
tion and  state  of  newness  of  the  article  in  question.  The 
existence  of  new  and  better  types  is,  of  course,  a  risk  that 
ought  to  be  provided  for  by  depreciation,  but  fluctuations  in 
the  value  caused  by  an  increase  or  reduction  in  the  cost  of  pro- 
ducing similar  machines  in  no  way  affect  the  cost  of  the  orig- 
inal machine  that  has  to  be  written  off  over  a  term  of  years. 


Comparative  Table. 


Reduced  by 
on  Cost 

Reduced  by 
per  annum 

Re- valued 
(say) 

Cost  (including  Erection) 
Depreciation  i 

$600. 00 
87.50 

600.     00 
165 .00 

$600.00 
200.00 

"            2      .  .      .  . 

512.50 
87.50 

435-00 
119 .60 

400.00 
75.00 

3        •      •• 

425 .00 
87-50 

315-40 
86.75 

325.00 
75.00 

4     ..      .. 

337-50 
87-50 

228.65 
62  .90 

250.00 
50.00 

5      •        •■ 

250. 00 
8750 

165-75 
45.60 

200.00 
50.00 

6      .  .      .  . 

T62.50 
87-50 

120.15 
3305 

150.00 
75.00 

Estiated  Break-up  Value 

$75-00 

*$87.io 

$75-00 

With  these  preliminary  remarks  we  may  proceed  to  the 
special  features  in  connection  with  the  depreciation  of  various 
classes  of  assets  to  be  considered. 

LAND  may  quickly  be  dismissed — it  suffers  no  depreciation. 
Fencing,  and  other  similar  works,  would,  of  course,  depreciate, 
but  the  item  would  not  usually  be  of  sufficient  importance  to 
require  consideration.  If,  however,  it  became  a  large  item, 
it  should  be  treated  separately  as  plant  (q.  v.). 

♦The  estimate  is  (it  will  be  seen)  too  large.  It  is,  however,  no  serious  matter  to 
charge  the  whole  of  the  deficit — $12.10 — against  the  sixth  year's  profits,  increasing 
that  charge  to  $45.15. 


190  AUDITING. 

BUILDINGS  depreciate  to  an  extent  varying  greatly  ac- 
cording to  the  quality  of  the  workmanship  and  materials  em- 
ployed in  their  erection.  The  amount  of  the  ledger  account 
will  frequently  include  land,  which,  as  we  have  seen,  does  not 
depreciate;  the  depreciation  will,  therefore,  be  confined  to  the 
building  itself.  If  the  instalment  plan  be  adopted,  from  one 
and  one-fourth  to  three  (or  even  five)  per  cent,  of  the  original 
amount  may  be  deducted  annually;  if  the  annuity  method  be 
used  a  fixed  sum  debited  to  revenue,  which,  after  crediting  in- 
terest, will  write  the  asset  down  to  zero  in  from,  say,  fifty  to 
one  hundred  and  fifty  years ;  or,  if  the  sinking  fund  system  be 
preferred,  such  a  sum  may  be  set  aside  as  will  accumulate  to 
the  cost  of  the  building  in  that  time.  In  each  case  all  repairs  will 
have  to  be  borne  by  revenue,  in  addition  to  the  depreciation. 
With  regard  to  the  relative  merits  of  the  instalment,  annuity, 
and  sinking  fund  methods,  the  latter  two  are  distinctly  prefer- 
able ;  although — on  account  of  its  greater  simplicity — the  instal- 
ment method  is  frequently  used  for  short  leases.  The  annuity 
system  differs  from  the  sinking  fund  in  that  the  instalments 
are  not  invested;  the  (net)  amount  of  each  successive  instal- 
ment therefore  requires  to  be  increased  to  compensate  for  loss 
of  interest  on  the  previous  uninvested  instalments. 

The  student  who  is  not  familiar  with  the  best  methods  of 
calculating  annuities,  &c.,  is  referred  to  a  very  good  treatise  on 
this  and  other  subjects,  entitled  "  The  Accountancy  of  Invest- 
ment," by  Charles  E.  Sprague,  Ph.D.,  C.P.A. 

GOODWILL  does  not  "  depreciate.''  On  the  other  hand, 
it  will  generally  be  conceded  that  it  is  liable  to  fluctuations, 
both  continual  and  extreme ;  as,  however,  no  one  would  think 
of  calling  its  omission  from  a  balance  sheet  a  secret  reserve, 
it  will  probably  be  most  convenient  to  deal  with  the  question 
of  goodwill  under  the  present  heading.  As  a  matter  of  fact, 
goodwill  is  not  written  down  because  its  value  is  supposed 
to  have  become  reduced — such  a  course  is  all  but  unknown. 
The  amount  at  which  goodwill  is  stated  in  a  balance  sheet  is 


DEPRECIATION.  I9I 

never  supposed  to  represent  either  its  maximum  or  its  mini- 
mum value;  no  one  who  thought  of  purchasing  a  business 
would  be  in  the  least  influenced  by  the  amount  at  which  the 
goodwill  was  stated  in  the  accounts;  in  short,  the  amount  is 
absolute  meaningless,  except  as  an  indication  of  what  the 
goodwill  may  have  cost  in  the  first  instance.  Inasmuch,  there- 
fore, as  nobody  can  be  deceived  by  its  retention,  there  is  no 
necessity  for  the  amount  of  goodwill  account  to  be  written 
down.  On  the  other  hand,  the  practice  is  not  unusual,  where 
sufficient  profits  are  being  made.  The  question  is  not,  how- 
ever, one  upon  which  the  auditor  is  required  to  express  an 
opinion;  and,  so  long  as  the  item  is  separately  stated  in  the 
balance  sheet,  it  is  scarcely  desirable  that  he  should  interfere 
with  the  discretion  of  the  management,  although  there  is,  of 
course,  no  objection  to  his  offering  an  opinion  when  he  is  in- 
vited to  do  so. 

HORSES  invariably  depreciate,  and — if  heavily  worked — 
very  rapidly.  The  rate  of  depreciation  will  probably  vary 
between  fifteen  and  twenty-five  per  cent,  on  the  starting  balance 
of  the  account.  Until  experience  has  shown  the  actual  rate  of 
depreciation,  it  will  be  safer  to  arrive  at  the  result  by  a  re- 
valuation (which  with  horses  can  be  more  accurately  done 
than  with  most  things),  and  where  only  a  small  number  of 
horses  are  employed  (say  twenty  or  less)  the  re-valuation 
should  often  be  resorted  to,  if  only  as  a  check  upon  the  rate  of 
depreciation  employed. 

INVESTMENTS  need  not  be  depreciated  unless  of  a  wast- 
ing nature — such  as  shares  in  mines  or  single-ship  companies. 
As  to  how  far  it  is  desirable  that  fluctuations  in  their  value 
should  be  considered,  the  reader  is  referred  to  the  paragraph 
on  "  Secret  Reserves  "  (postea). 

LEASEHOLD  LAND  AND  PREMISES.— The  premium 
paid  for  leases  may  be  regarded  as  the  purchase-money  paid 
for  a  terminable  annuity  of  the  difference  between  the  annual 
value  of  the  property  and  the  annual  charges.     In  short-term 


192  AUDITING. 

leases  the  readiest  method  will  be  to  charge  a  proportionate 
part  of  the  term  against  each  year's  revenue ;  but  the  method 
is  too  rough  to  be  employed  if  the  term  exceeds,  say,  eight  or 
ten  years.  In  the  case  of  longer  leases  the  annuity,  or  sinking 
fund,  plans,  which  were  discussed  under  the  heading  "  Build- 
ings," should  be  adopted.  Sometimes  the  termination  of  a 
lease  finds  the  late  lessee  liable  to  a  claim  for  dilapidations; 
this  claim  may  amount  to  one  year's  rent,  or  even  more,  and  it 
is  therefore  a  convenient  and  prudent  course  to  adopt  to  deduct 
about  one  year  from  the  unexpired  term  of  the  lease  before 
making  the  depreciation  calculations.  All  repairs  are,  of  course, 
chargeable  to  revenue ;  but  they  may  be  averaged  by  the  tem- 
porary or  permanent  employment  of  a  repairs  (fund)  account 
through  which  revenue  is  charged  with  a  fixed  amount  annual- 
ly, the  difference  between  the  actual  expenditure  and  the  annual 
charge  being  brought  forward  as  a  liability,  or  (more  rarely) 
as  an  asset. 

Before  leaving  this  point  it  is  well  to  bear  in  mind  that,  in 
the  case  of  exceptionally  long  leases,  or  exceptionally  badly 
built  premises,  it  may  be  necessary  to  increase  the  annual 
charges  for  depreciation  beyond  the  usual  rate,  so  as  to  pro- 
vide for  the  re-building  of  the  structure  during  the  lease. 

MACHINERY  depreciates  by  wear  and  tear,  and  by  be- 
coming obsolete.  In  addition  to  charging  all  repairs  and 
(partial)  renewals  to  revenue,  from  seven  and  one-half  to. 
twelve  and  one-half  per  cent,  should  be  written  off  annually 
from  reducing  balances.  Boilers,  which  depreciate  more 
rapidly,  should  be  reduced  from  ten  to  fifteen  per  cent,  per 
annum.  Loose  tools  are  most  conveniently  dealt  with  by 
means  of  a  re-valuation.  It  is  desirable  that  a  sound  prac- 
tical opinion  be  obtained  as  to  the  precise  rate  to  be  adopted 
in  any  particular  case,  and  a  thorough  re- valuation  from  time 
to  time  is  very  desirable. 

The  practice  of  having  a  subsidiary  ledger  containing  the 
details  of  the  machinery  account  in  the  general  ledger  should 


DEPRECIATION.  I93 

always  be  advocated.  It  greatly  facilitates  the  labor  of  se- 
curing rates  of  depreciation,  and  is  invaluable  in  case  of  fire, 
and  in  fact  for  many  other  purposes,  such  as  determining  the 
amount  to  be  written  off  in  the  event  of  sales. 

The  rates  of  depreciation  on  machinery  are  discussed  more 
frequently  than  any  others,  no  doubt  because  they  are  more 
difficult  to  fix. 

In  this  connection  the  following  extract  from  an  address 
on  **  Depreciation,  Renewal  and  Replacement  Accounts,"  by 
Herbert  G.  Stockwell,  C.  P.  A.,  delivered  before  the  annual 
meeting  of  The  American  Association  of  PubHc  Accountants, 
held  in  Denver,  October,  1909,  is  of  interest: 

"  I  think  it  can  be  confidently  asserted  that  there  are  no 
two  manufacturing  plants  in  this  country  in  which  the  man- 
agement is  sufficiently  identical  in  character,  ability  and  tem- 
perament that  a  depreciation  charge  in  the  same  amount,  or  on 
the  same  percentage  basis,  could  be  correctly  used  in  both. 
This  being  true,  how  useless  it  is  to  attempt  to  form  aver- 
ages for  the  life  of  machines  in  all  plants,  ^ven  in  the  same 
lines  of  business !  " 

All  interested  in  the  question  of  depreciation  should  read 
Mr.  Stockwell's  exhaustive  and  valuable  paper;  it  may  be 
found  in  the  Year  Book  of  The  American  Association  for  1909, 
published  by  The  Accountancy  Publishing  Co.,  New  York. 

MINES,  undoubtedly,  depreciate  in  direct  proportion  to 
the  amount  of  mineral  extracted.  By  a  singular  inconsistency 
of  the  law,  however,  no  depreciation  need  be  provided  for  by 
a  mining  company  before  declaring  a  dividend.  Where  de- 
preciation is  provided,  the  correct  method  appears  to  be  to 
write  off  annually  such  proportion  of  the  total  cost  (less  resi- 
dual value  of  plant)  as  the  year's  output  bears  to  the  estimated 
contents  of  the  mine,  or — in  the  case  of  a  lease — such  pro- 
portion of  the  total  cost  as  the  year's  output  bears  to  the  esti- 
mated total  output  during  the  lease. 


194  AUDITING. 

On  the  other  hand,  it  inust  not  be  forgotten  that  there  is 
so  much  uncertainty  about  mining  ventures  that  it  would  be 
practically  impossible,  merely  by  the  adoption  of  any  system 
of  accounts,  to  insure  that  the  whole  of  the  capital  of  the 
undertaking  was  always  maintained  intact;  while  the  persons 
who  invest  in  this  class  of  concern  would  doubtless  object  to 
large  funds  accumulating  in  the  hands  of  directors,  and  earn- 
ing a  low  rate  of  interest,  which  might  legally  be  distributed 
as  dividend,  even  though  in  point  of  fact  they  constitute  a 
return  of  capital.  Perhaps,  therefore,  it  is  best  that  mines 
should  be  regarded  as  coming  under  a  distinct  category  as 
"  non-permanent "  undertakings,  the  excess  of  current  ex- 
penditure being  distributed,  irrespective  of  the  value  of  the  re- 
maining assets  as  contrasted  with  the  paid-up  capital. 

PLANT,  other  than  machinery,  generally  runs  compara- 
tively little  risk  of  becoming  obsolete,  and  a  deduction  of  from 
five  to  seven  and  one-half  per  cent,  will,  therefore,  usually 
suffice.  Furniture  and  Fittings  should,  however,  be  sub- 
jected to  a  somewhat  higher  rate.  In  both  cases  an  occasional 
re-valuation  will  be  desirable. 

Plant  (or  machinery)  acquired  upon  the  hire-purchase  sys- 
tem must,  of  course,  be  depreciated.  Under  normal  circum- 
stances the  depreciation  will  be  in  accordance  with  the  nature 
of  the  asset,  whatever  it  may  be.  It  should  be  borne  in  mind, 
however,  that  if  full  depreciation  be  charged  during  the  cur- 
rency of  the  agreement,  in  addition  to  the  proper  interest 
instalments,  the  consequence  will  not  infrequently  be  to  charge 
against  the  profits  of  the  earlier  years  a  sum  in  excess  of  what 
it  would  have  cost  to  merely  hire  the  articles  in  question.  The 
cost  of  simple  hire  may  fairly  be  regarded  as  the  maximum 
amount  that  need  ever  be  charged  against  profits  for  the  use  of 
any  asset,  consequently  the  full  provision  for  depreciation  may 
require  to  be  modified  during  the  currency  of  the  hire-purchase 
agreement. 

PATENTS  are  virtually  leases  of  a  monopoly,  and  although 
it  is  possible  that  some  value — in  the  nature  of  goodwill — 


DEPRECIATION.  1 95 

may  remain  after  the  patent  has  run  out,  it  seems  desirable 
that  the  cost  of  a  patent  should  be  written  off  within  the  course 
of  its  life.  Where  a  patent  has  not  been  purchased,  but  re- 
mains the  property  of  the  original  patentee,  it  is  very  undesir- 
able that  the  item  should  be  treated  as  an  asset  at  all,  except  to 
the  extent  of  its  actual  cost  in  fees,  &c. :  such  a  course  would 
seem  to  be  every  bit  as  artificial  as  a  similar  treatment  of  good- 
will, which  sans  dire  is  a  latent  asset  in  every  paying  concern. 

A  similar  mode  of  treatment  will  apply  to  Copyrights^  ex- 
cept that  their  commercial  value  has  usually  expired  long  be- 
fore the  copyright  has  run  out.  (See  further  under  "Publish- 
ers' Accounts.") 

SHIPS  undeniably  depreciate,  although  the  rate  at  which 
they  do  so  is  so  variable  that  no  general  rules  can  be  given 
that  would  prove  of  any  practical  utility.  The  amount  of 
depreciation  is  usually  certified  by  a  competent  engineer,  and, 
therefore — so  long  as  his  report  looks  plausible — the  auditor 
is  relieved  from  imdue  responsibility.  So  long  as  the  auditor's 
certificate  makes  it  perfectly  clear  that  no  depreciation  is 
being  laid  aside,  and  so  long  as  the  Courts  see  no  illegality  in 
such  a  course,  there  does  not  appear  to  be  any  valid  objection, 
from  an  auditor's  point  of  view,  that  is  not  outweighed  by  the 
resultant  advantages. 

THEATRICAL  PLANT,  &c.— Although  there  can  be  no 
reasonable  doubt  that  theatrical  scenery,  "  props.,"  and  other 
stock-in-trade  are  liable  to  depreciation,  it  is  probable  that  few 
accountants  would  care  to  accept  the  responsibility  of  settling 
the  actual  amount.  So  far  as  the  author  has  been  able  to  ascer- 
tain, the  only  practice  in  vogue  is  a  periodical  re-valuation, 
and  it  will  very  likely  recommend  itself  to  the  auditor  as 
being,  perhaps,  the  safest  course.  Copyrights  and  Per- 
forming Rights,  when  not  purchased  upon  "  sharing  "  terms, 
will  also  require  to  be  dealt  with;  but,  unless  there  appear  to 
be  very  good  reasons  for  believing  that  a  "  revival "  at  no 
very  distant  date  would  prove  remunerative,  it  would  probably 


196  AUDITING. 

be  considered  safest  to  regard  the  whole  cost  as  a  mounting 
expense. 

REPAIRS  will,  in  all  cases,  require  to  be  charged  against 
profit  and  loss;  but,  with  a  view  to  equalizing  profits,  it  is 
a  very  good  plan  to  charge  a  fixed  sum  to  profit  and  loss, 
and  to  credit  that  sum  to  a  '*  Reserve  for  Repairs  Account," 
against  which  account  the  actual  repairs  will  be  debited.  Ex- 
cept in  very  special  cases,  however,  a  debit  balance  on  the 
reserve  account  should  not  be  passed  as  an  asset.  If  the 
amount  expended  upon  repairs  is  below  the  average  of  pre- 
vious years,  it  may  be  desirable  to  reconsider  the  value  of  the 
property  itself. 

LANDLORD'S  FIXTURES.— In  the  case  of  plant,  ma- 
chinery and  fittings  erected  upon  leasehold  property,  it  is  im- 
portant not  to  lose  sight  of  the  fact  that,  so  far  as  these  be- 
come landlord's  fixtures,  the  minimum  rate  of  depreciation 
permissable  is  one  that  will  entirely  write  off  the  book-value  by 
the  time  the  lease  expires.  The  question  as  to  what  are,  and 
what  are  not,  landlord's  fixtures  is,  however,  far  too  intricate 
to  be  usefully  dealt  with  here. 

A  few  years  ago  the  author  contributed  a  volume  on 
"  Depreciation,  Reserves  and  Reserve  Funds "  to  the  "Ac- 
countants' Library"  series  (Vol.  XXVI.).  Numerous  pamph- 
lets, articles  and  lectures  on  this  subject  by  leading  American 
accountants  have  in  addition  appeared  from  time  to  time,  and 
reference  to  them  may  readily  be  had. 

PROVISION  FOR  BAD  AND  DOUBTFUL  DEBTS. 

Unless  the  outstanding  book  debts  are  extremely  numerous, 
it  is  desirable  that  the  auditor  should  go  over  the  list  in  com- 
pany with  his  client,  or  the  manager,  or  some  equally  respon- 
sible authority,  and  settle  the  amount  of  loss  to  be  provided 
for.  Where  the  number  of  accounts  renders  this  course  im- 
practicable, a  certified  list  of  amounts  to  be  treated  as  bad, 
and  a  statement  that  the  provision  made  is  sufficient,  signed 


PROVISION  FOR  BAD  AND  DOUBTFUL  DEBTS.  I97 

by  the  aforesaid  responsible  authority,  should  be  supplied  to 
the  auditor.  It  is  a  fact  that  sometimes  an  experienced  ac- 
countant will  give  a  far  more  reliable  valuation  to  book  ac- 
counts than  the  owner  or  manager  of  a  business  can  do.  No 
doubt  the  training  and  experience  of  an  accountant  help  him 
in  many  ways  to  gauge  the  probable  realizable  value  of  book 
debts;  but  unless  his  experience  be  confined  to  one  particular 
industry  (or  at  most  to  a  few  industries),  his  knowledge  of 
the  financial  standing  of  the  customers  can  of  necessity  be 
only  fragmentary  at  the  best.  It  is,  moreover,  thought  to  be 
undesirable  for  an  auditor  to  differ  from  the  deliberate  opinion 
of,  say,  a  manager,  unless  he  is  prepared  to  give  solid  reasons 
in  support  of  his  views.  On  the  other  hand,  it  is  not  intended 
to  suggest  that,  merely  because  the  auditor  has  been  supplied 
with  a  certified  list  of  the  provision  which  it  is  thought  neces- 
sary to  make  for  bad  and  doubtful  debts,  all  he  has  to  do 
is  to  accept  it  without  further  comment  or  inquiry.  It,  of 
course,  remains  for  the  auditor  to  satisfy  himself  that  the  pro- 
vision is  one  which  appears  to  be  both  bona  fide  and  reasonable. 
In  this  connection  the  following  extract  from  an  article  which 
appeared  in  The  Accountant  will  be  found  useful : — 

"With  trading  concerns  debtors  who  always  take  a  cash  discount 
may,  in  the  absence  of  information  to  the  contrary,  always  be  assumed 
to  be  good  for  any  outstanding  balance  not  greatly  in  excess  of  their 
ordinary  amount.  Debtors  who  always  give  notes  for  their  accounts 
may,  under  similar  circumstances,  be  regarded  as  good,  provided  the 
notes  are  always  met  at  maturity  without  renewal.  Where  there  are 
renewals,  the  accounts  should  be  examined  more  carefully;  and,  as  the 
number  of  cases  would  not  be  large,  this  detailed  inquiry  would  not 
be  impracticable.  Accounts  showing  an  increasing  debit  balance  require 
more  careful  scrutiny  than  those  where  the  balance  is  reduced, 
more  particularly  if  the  number  of  transactions  during  the  period 
be  small.  In  the  case  of  interest-bearing  debts,  the  punctual  payment 
of  the  interest  may  be  taken  as  presumptive  evidence  that  the  principal 
is  good,  provided  it  be  not  in  arrear ;  but  where  the  interest  is  in  arrear, 
the  presumption  is  that  the  debt  is  at  least  doubtful,  unless  sufficient 
security  is  held  to  cover  the  amount.  *  Dead '  accounts  are  more  likely 
to  be  doubtful  or  bad  than  'live'  accounts;  and  in  this  connection  a 
debtor  who,  during  the  current  year,  has  not  paid  enough  cash  to  extin- 


198  AUDITING. 

guish  the  balance  against  him  at  the  commencement  of  the  year,  may 
generally  be  regarded  as  a  'dead'  account,  and  treated  accordingly. 
Apart  from  the  open  balances  standing  against  the  various  debtors  in 
the  customers'  ledgers,  it  is  important  not  to  lose  sight  of  unmatured 
notes,  whether  these  be  in  hand  or  have  been  discounted;  but,  as  has 
already  been  stated,  a  customer  who  invariably  meets  his  notes  at 
maturity  may  usually  be  regarded  as  safe  to  continue  to  do  so." 

It  may  be  added  that,  in  many  cases,  there  should  be  a 
fairly  constant  ratio  between  the  amount  of  outstanding  book 
debts  and  the  total  of  the  sales  on  credit  during  (say)  the  last 
three  months. 

Although  it  is  very  undesirable  that  an  insufficient  provision 
be  made  for  bad  debts,  it  should — on  the  other  hand — be  re- 
membered that,  when  once  a  debt  is  written  off,  its  chance  of 
being  eventually  collected  is  greatly  discounted;  and,  further, 
that  there  is  at  least  the  possibility  of  its  not  being  accounted 
for,  even  if  collected:  hence  the  advisability  of  adopting  the 
system  already  described.   (  Vide  page  yy.) 

OUTSTANDING  DISCOUNTS- 

The  usual  cash  discounts,  upon  both  book  debts  and  trade 
creditors  are  sometimes  provided  for  by  means  of  a  suspense 
account.  Where,  however,  the  amount  is  uncertain  (by  reason 
of  the  variable  nature  of  the  payments)  and  the  difference  be- 
tween the  two  sides  is  but  slight,  the  provision  might  be 
omitted  without  any  great  harm  being  done — indeed,  it  is  a 
very  open  question  whether  the  profit  or  loss — as  the  case  may 
be — ought  to  be  anticipated.  Trade  discounts  are,  however, 
a  very  different  matter,  and  should  be  provided  for  by  deduc- 
tion from  the  purchases  and  sales  respectively. 

It  has  been  stated  that  every  credit  transaction  involves  the 
consideration  of  interest  or  discount — a  statement  which  is, 
doubtless,  theoretically  unassailable,  but  practically  inconven- 
ient. As  a  matter  of  fact,  there  is  no  relation  between  the 
usual  so-called  "  cash  "  discount  and  the  rate  which  is  paid  for 


DIRECTORS    FEES.  1 99 

borrowed  money.  These  discounts  run  from  ^  of  i'%,  for 
cash  within  ten  days,  to  5%  for  the  same  period,  the  terms  in 
both  cases  being  thirty  days  net.  It  is  not  to  be  presumed 
that  in  one  case  the  trader  is  wilHng  to  pay  9%  per  annum  for 
prompt  collections  and  in  the  other  case  90*%-  It  is  merely 
a  premium  or  bonus  paid  for  prompt  payment,  and  in  most 
cases  is  in  effect  a  trade  discount. 

In  the  case  of  banks  and  other  financial  houses,  interest 
(which  is  no  longer  obscured  by  trade  profits,  but  is  itself  the 
source  of  all  profit)  should,  of  course,  be  always  taken  into 
account,  but,  as  stated  heretofore,  the  almost  invariable  prac- 
tice for  American  banks  is  to  ignore  this  matter. 


DIRECTORS*  FEES. 

In  the  absence  of  any  special  arrangement  contained  either 
in  the  articles  of  association  or  in  the  minutes  of  general  meet- 
ing, directors  are  entitled  to  no  remuneration  in  respect  of 
their  services.  The  auditor  will  require  to  see,  therefore, 
before  passing  any  such  remuneration,  that  provision  is  con- 
tained therefor  in  the  by-laws,  or  else  that  the  remuneration 
has  been  voted  by  the  stockholders  in  general  meeting.  He 
would  also  require  to  see  that  the  amount  which  the  directors 
have  received  is  in  accordance  with  such  provisions.  Proper 
vouchers  should  be  given  by  directors  for  fees  received  by 
them.  It  is  not  likely  that  under  any  circumstances  objection 
could  be  raised  to  reasonable  attendance  fees,  but  it  would 
seem  from  reference  to  leading  American  authorities  on  our 
corporation  laws  that  the  practice  of  voting  large  salaries  and 
other  compensation  to  directors  is  ultra  vires.  Of  course,  if 
the  by-laws  distinctly  provide  for  such  compensation,  no  ob- 
jection can  be  raised.  It  is,  perhaps,  superfluous  to  state  that 
no  one  who  is  not  a  director  can  be  entitled  to  receive  direct- 
ors' fees,  and  it  is  a  very  fair  question  as  to  whether  directors 
who  are  also  officers  of  a  company,  and  who  draw  salaries  as 
such,  are  entitled  to  receive  directors'  fees  in  addition. 


200  AUDITING. 

PRELIMINARY  EXPENSES. 

In  the  balance  sheet  of  almost  every  young  company  this 
item  will  be  found  among  the  assets.  It  will  probably  sur- 
prise few,  to  learn  that  with  a  considerable  number  of  com- 
panies this  item  is  not  written  off,  and,  while  it  disappears 
as  a  separate  item,  it  remains  capitalized.  It  is,  however,  very 
desirable  to  write  off  the  amount  of  the  preliminary  expenses 
within  the  first  three  or  five  years;  and  the  auditor  will  do 
well  to  recommend  the  adoption  of  such  a  course. 

It  must  not  be  forgotten  that,  in  every  case,  the  auditor 
must  thoroughly  verify  the  amount  of  this  item  by  reference 
to  vouchers  and  contracts.  In  particular,  he  should  make  sure 
that  the  company  has  made  no  payments  that  the  promoters 
undertook  to  pay,  or  which — for  other  reasons — may  appear 
improper.  It  is  not  an  unknown  occurrence  for  directors' 
qualifications  to  be  paid  for  out  of  preliminary  expenses. 

RESERVE  FUNDS. 

It  is  very  generally  conceded,  and  therefore  need  not  be 
discussed  at  length  in  these  pages,  that  it  is  not — ^under  ordi- 
nary circumstances — desirable  that  a  reserve  fund  be  specially 
invested  if  the  moneys  can  be  utilized  to  better  advantage  in 
the  business  itself  or  in  reducing  its  liabilities.  Where,  how- 
ever, the  fund  is  specially  raised  for  a  specific  purpose  (e.  g., 
the  redemption  of  bonds),  its  investment  would  appear  to  be 
desirable  for  the  purpose  of  insuring  its  being  available  at  the 
appointed  time.  Of  course,  wherever  a  specific  provision  is 
made  in  a  mortgage  (as  is  frequently  the  case)  requiring  the 
fund  to  be  invested,  it  will  be  necessary  to  carefully  examine  all 
the  provisions  relating  thereto  in  order  to  be  sure  that  the  in- 
vestments are  properly  made.  Where  the  reserve  fund  exists 
for  the  purpose  of  strengthening  the  credit  of  the  company — 
as  in  the  case  of  banks — it  is  doubtless  desirable  that  it  should 
be  iirvested  in  first-class  securities;  but  it  is  no  part  of  the 
auditor's  functions  to  interfere  with  the  management  in  this 


INSPECTION   OF  MINUTE   BOOK.  20I 

r.espect.    The  whole  subject  is,  however,  dealt  with  very  fully 
in  the  following  chapter. 

Unless  there  is  a  special  provision  in  the  by-laws,  there  is 
nothing  to  prevent  directors  from  transferring  the  whole  or 
any  portion  of  the  amount  standing  to  the  credit  of  reserve 
fund  to  the  credit  of  profit  and  loss  account,  for  the  purpose 
of  increasing  the  amount  of  profits  available  for  dividends. 
Where  such  a  course  is  being  pursued,  the  auditor  should, 
however,  take  steps  to  acquaint  the  stockholders  with  the  facts, 
unless  they  are  shown  with  sufficient  clearness  on  the  face  of 
the  accounts. 

It  is  obviously  desirable  that  premiums  received  on  issues 
of  stocks  should  be  placed  to  the  credit  of  a  permanent  re- 
serve fund,  and  not  applied  to  the  equalization  of  dividends; 
nor  should  they  be  included  in  the  surplus,  or  current  profit 
and  loss  account,  as  ordinary  earnings  or  income.  With  re- 
spect to  premiums  received  on  bond  issues  (if  the  premium 
arises  as  a  matter  of  fact  from  the  rate  of  interest  which  the 
bonds  bear),  it  would  seem  proper  that  the  premiums  so  re- 
ceived should  be  set  up  and  distributed  ratably  over  the  life 
of  the  bonds  as  a  reduction  of  the  current  interest  account. 
This,  of  course,  follows  the  theory  laid  down  with  respect  to 
bonds  issued  at  a  discount. 

INSPECTION  OF  MINUTE  BOOK. 

The  question  frequently  arises,  and  is  the  source  of  no  little 
contention,  as  to  whether  an  auditor  has  the  right  to  inspect 
the  minute  book  recording  the  proceedings  at  board  meetings. 
It  is  thought,  however,  that  this  right  cannot  be  disputed, 
inasmuch  :as  it  is  clearly  the  duty  of  the  auditor  to  certify  to  the 
accounts  after  having  examined  "  the  books  of  the  company  ;'* 
and  certainly  the  minute  book  is  a  "  book  of  the  company," 
inasmuch  as  it  is  one  of  the  few  books  which  every  compaiiy 
is  required  by  all  corporation  laws  to  keep.  Theoretically,  at 
least,  it  is  necessary  that  the  auditor  should  carefully  examine 


202  AUDITING. 

the  whole  contents  of  the  minute  book,  but  in  practice  it  is 
thought  that  this  rule  may  frequently  be  relaxed,  and  reference 
only  made  in  respect  to  items  upon  which  the  auditor  is  in 
doubt,  or  with  regard  to  which  he  requires  further  elucidation. 
It  need  hardly  be  added,  however,  that  in  this  respect — as  with 
regard  to  all  other  matters  where  the  auditor  prefers  to  take  a 
short  cut  in  his  work — he  does  so  at  his  own  risk,  and  the  risk 
in  this  particular  connection  is  that  he  may  fail  to  become 
acquainted  with  some  contingent  liability  or  contract  which 
would  materially  alter  his  views  with  reference  to  the  accounts 
which  he  is  called  upon  to  certify. 

If  an  auditor  is  refused  faciHties  for  performing  his  duties, 
whether  such  refusal  takes  the  form  of  declining  to  allow 
him  access  to  any  of  the  books,  accounts,  or  vouchers  of  the 
company,  or  to  the  failure  of  the  directors  or  officers  of  the 
company  to  give  such  information  or  explanations  as  may  be 
necessary,  the  auditor  should  sign  a  certificate  at  the  foot  of 
the  balance  sheet  stating  that  all  his  duties  as  auditor  have  not 
been  complied  with. 

REDEEMABLE  STOCKS  AND  BONDS. 

Where  preference  stocks  or  bonds,  redeemable  at  par  or  at 
a  premium,  have  been  issued  at  a  lower  rate,  it  is  essential  that 
a  proper  reserve  be  made  to  meet  the  deficit;  and, it  will  be 
the  auditor's  duty  to  see  that  a  sufficient  provision  is  made. 

FORFEITED  SHARES. 

Where  shares  have,  for  any  reason,  been  forfeited  to  the 
company,  and  have  not  been  re-issued,  they  should  be  sepa- 
rately stated  on  the  balance  sheet,  as  a  dividend  declared  would 
not  be  payable  in  respect  thereof.  Such  shares  may  at  any 
subsequent  date  be  re-issued  at  any  discount  not  exceeding  the 
amount  per  share  already  received,  and  when  so  re-issued  the 
amount  already  paid  (or  so  much  thereof  as  represents  profit) 
should  be  treated  as  a  premium  upon  issue,  and  credited  to  a 


FLUCTUATIONS  IN  ASSETS  AND  SECRET  RESERVES.  2O3 

reserve  account.  The  auditor  should  always  make  a  point  oi 
seeing  that  the  minutes  as  to  forfeiture  and  as  to  the  calls  due 
are  prima  facie  in  order. 

FLUCTUATIONS  IN  ASSETS  AND  SECRET 
RESERVES. 

This  most  debatable  subject  is  approached  with  considerable 
diffidence.  Very  much  can  be  (and  has  been)  said  upon  both 
sides  of  the  question,  making  it  a  most  difficult  thing  to  say 
what  is  really  the  correct  course  to  adopt  in  any  particular 
case ;  and,  if  the  question  be  complicated,  even  when  a  particu- 
lar instance  is  judged  upon  its  merits,  how  much  more  difficult 
is  it  to  lay  down  any  general  rules  of  universal  application. 

The  object  of  all  secret  reserves  created  in  good  faith  is  to 
equalize  dividends,  or  to  equalize  apparent  profits ;  and,  in  the 
case  of  banks  and  similar  institutions,  it  must  be  admitted  that, 
were  accounts  published  showing  considerable  fluctuations  in 
the  amount  of  profits  earned,  the  result  might  readily  be  to  pro- 
duce a  feeling  of  disquietude  which  was  altogether  unwar- 
ranted by  the  actual  facts.  More  particularly  in  the  case  of 
banks  largely  affected  by  fluctuations  in  exchange  does  it  seem 
desirable  that  the  temporary  effect  of  such  fluctuations  should 
be  excluded  from  published  accounts.  The  understating  of 
assets  in  profitable  years  (which  is  the  ordinary  means  of  pro- 
viding a  secret  reserve)  clearly  contemplates,  however,  the 
possibility  of  their  being  written  up  in  less  profitable  years, 
when  it  may  be  desired  not  to  disclose  the  fact  that  the  profit 
earned  has  been  less  than  usual,  or  perhaps  even  insufficient 
to  cover  the  proposed  dividend. 

Opinions  differ  greatly  as  to  the  extent  to  which  the  forma- 
tion of  secret  reserves  is  permissible;  but  it  is  thought  that, 
within  reasonable  limits,  the  matter  is  one  resting  with  the 
directors  rather  than  with  the  auditor,  so  long  as  there  is  no 
suspicion  of  bad  faith.  It  is  when  it  is  sought  to  have  recourse 
to  a  secret  reserve  by  writing  up  the  assets  which  have  hitherto 


204  AUDITING. 

been  undervalued  that  the  position  requires  the  most  serious 
consideration  of  the  auditor. 

With  regard  to  the  position  of  the  auditor  generally,  it  would 
appear  that,  in  the  absence  of  mala  Mes,  he  incurs  but  little 
responsibility.  He  should,  however,  be  very  careful  about  the 
good  faith  with  which  the  valuations  or  re-valuations  are  made, 
and  although  he  has  no  power  to  influence  the  management 
in  the  exercise  of  their  bona  iide  discretion,  yet  it  would  appear 
to  be  clearly  his  duty,  in  cases  of  doubt,  to  sufficiently  acquaint 
the  stockholders  with  the  facts  of  the  case  to  enable  them  to 
intelligently  exercise  their  own  discretion  as  to  whether  they 
will  pass  the  accounts  in  the  form  in  which  they  are  presented 
to  them  or  not.  Thus,  where  the  assets  are  stated  below  their 
certainly-known  value  (forming  a  secret  reserve),  or  above 
their  certainly-known  value  (forming  a  secret  deficit),  at  least 
the  bare  fact  should  be  mentioned  in  the  auditor's  report. 
Again,  there  are  limits  to  the  extent  with  which  a  secret  re- 
serve should  be  played  with,  for  the  sake  of  equalizing  divi- 
dends ;  and  it  is  very  undesirable  that  valuable  assets  should  be 
omitted  from  the  balance  sheet  in  ioto,  because  in  such  a  case 
the  auditor  is  very  liable  to  omit  to  verify  their  existence.  In 
some  balance  sheets  a  note  is  appended  to  the  effect  that 
certain  (specified)  assets  have  not  been  included.  Such  a 
course  appears  to  remove  the  most  weighty  objections  that  can 
be  raised  against  the  reduction  of  valuable  assets  to  zero,  but 
it  does  not  altogether  justify  the  course  adopted. 

FOREIGN   EXCHANGES. 

The  treatment  of  foreign  exchanges  in  books  of  account 
appertains  to  bookkeeping  rather  than  auditing,  and  the  sub- 
ject will  accordingly  be  found  fully  dealt  with  in  the  author's 
"Advanced  Accounting."  From  the  point  of  view  of  the  audi- 
tor, all  that  is  necessary  is  that  the  accounts  should  properly 
disclose  the  true  position  of  affairs.  For  this  purpose  it  is 
only  necessary  to  bear  in  mind  that  the  trial  balance  (from 
which  the  accounts  are  compiled)  is  a  summary  of  transactions 


205 

that  have  actually  taken  place,  temporarily  recorded,  for  the 
sake  of  convenience,  in  the  medium  of  a  foreign  currency.  To 
determine  their  proper  valuation  in  dollars  it  is  necessary  that 
the  nature  of  these  various  records  should  be  inquired  into; 
that  the  revenue  account  (whatever  its  precise  form)  should 
correctly  show,  under  suitable  headings,  the  totals  of  the  vari- 
ous kinds  of  transactions  on  account  of  revenue,  and  that  the 
balance  sheet  should  fairly  state  the  assets  and  liabilities — those 
of  a  current  nature  at  their  realizable  cash  value,  while  the 
fixed  or  permanent  items  may  be  maintained  at  the  original 
amount,  subject  only  to  such  provision  for  depreciation  as  may 
be  necessary  in  view  of  their  wasting  character.  If  this  posi- 
tion of  affairs  be  correctly  comprehended,  there  is  no  more 
difficulty  in  auditing  accounts  figured  in  a  foreign  currency 
than  in  auditing  accounts  the  narration  of  which  is  expressed  in 
a  foreign  language.  The  medium  of  expression  in  neither  case 
affects  the  nature  of  the  facts. 

ULTRA  VIRES. 

It  is  a  question  of  some  nicety  as  to  how  far  an  auditor  is 
expected  to  concern  himself  with  the  validity  of  the  trans- 
actions that  come  under  his  notice.  It  may  be  taken  that,  in 
general,  the  auditor  is  not  constituted  a  judge  of  the  conduct 
of  the  directors  in  their  administrative  capacity;  and  that,  so 
long  as  the  accounts  are  in  order,  and  in  accordance  with  such 
statutory  provisions  as  may  affect  the  particular  undertaking, 
and  its  articles  of  association  (or  their  equivalent),  the  audi- 
tor need  not  concern  himself  with  questions  which  his  profes- 
sional training  has  not  especially  qualified  him  to  solve.  It  is 
clear,  however  that  when  the  auditor  is  aware  that  irregu- 
larities have  been  committed,  it  becomes  his  duty  to  report  the 
whole  circumstances  to  the  stockholders. 

"AFTER  DISCOVERED  EVIDENCE." 

The  question  has  sometimes  been  raised  as  to  how  far,  if  at 
all,  an  auditor  should  take  cognizance  of  events  transpiring  be- 


206  AUDITING. 

tween  the  date  of  the  balance  sheet  which  he  is  to  certify  and 
the  date  he  actually  completes  the  audit.  It  has  been  con- 
tended by  some  that  the  auditor  should  view  the  accounts  in  the 
same  way  he  would  have  done  had  he  actually  made  his  audit 
(which,  of  course,  he  would  be  unable  to  do)  on  the  day  with 
which  the  audit  period  closed  and  that  he  should  not  be  influ- 
enced by  circumstances  which  were  unknown  at  that  time. 

This  contention  is  short-sighted  and  ultra-technical.  If  the 
auditor,  prior  to  certifying  to  the  accounts,  comes  into  posses- 
sion of  information  indicating  a  material  difference  between 
the  books  and  facts  as  they  actually  were  at  the  date  of  the  haU 
ance  sheet  (even  if  the  true  facts  have  only  been  ascertained 
since  that  time)  and  he  certifies  to  a  balance  sheet  drawn  from 
the  books  without  any  adjustment  being  made  to  bring  it  into 
accord  with  the  facts,  he  is  certifying  a  balance  sheet  which  is 
not  correct  according  to  the  best  of  his  information. 

It  should,  however,  be  borne  in  mind  that  these  remarks 
apply  only  to  circumstances  transpiring  in  the  interval  which 
throw  light  on  the  actual  condition  of  affairs  at  the  date  of  the 
balance  sheet  and  do  not,  of  course,  apply  to  events  which  may 
have  occurred  in  the  intervening  period  to  the  detriment  of  a 
company's  financial  condition — such  as  a  fire  loss  exceeding  the 
amount  of  insurance  recovered — which  have  no  connection 
with  a  prior  period. 

FORM  OF  ACCOUNTS. 

In  the  audit  of  private  accounts  and  most  corporations  it  is 
usual  for  the  auditor  to  recommend  the  particular  form  in 
which  the  accounts  shall  be  cast.  In  the  case  of  national 
banks,  however,  the  auditor  has  no  power  to  dictate  the  form 
in  which  the  accounts  shall  be  stated,  consequently  he  need  not 
concern  himself  with  the  consideration  as  to  whether  or  not 
the  form  adopted  is  the  most  suitable  one  under  the  particular 
circumstances  of  the  case ;  but,  if  he  is  convinced  that  the  form 
adopted  is  one  calculated  to  mislead,  he  should  not  hesitate  to 


FORM    OF    ACCOUNTS.  20/ 

modify  his  report  accordingly.  Nevertheless,  the  whole  ques- 
tion is  one  of  considerable  interest  and  accordingly  it  has  been 
thought  desirable  to  deal  with  it  at  some  length  in  the  following 
chapter. 

Where  a  statutory  form  of  accounts  (as  is  the  case,  in  some 
States,  with  railway  and  insurance  companies)  has  been  pro- 
vided, the  auditor  should  see  that  the  accounts  are  prepared 
in  accordance  with  that  form,  or  as  nearly  in  accordance  there- 
with as  circumstances  will  permit. 


CHAPTER  VII. 


FORM  OF  ACCOUNTS  AND  BALANCE 
SHEETS. 


It  has  already  been  clearly  stated  that,  in  general,  the  auditor 
is  not  responsible  for  the  form  of  accounts  which  he  certifies. 
The  consideration  of  the  form  that  such  accounts  should  prop- 
erly take  is,  therefore,  not  strictly  a  matter  within  the  scope 
of  the  present  work.  Still,  it  is  none  the  less  true  that,  as  a 
matter  of  fact,  auditors  are  frequently  asked  to  settle  questions 
of  form ;  and  although  in  the  case  of  certain  undertakings  like 
banks  and  insurance  companies,  where  departmental  forms  are 
prescribed,  they  will  often  be  only  prudent  if  they  decline  to 
accept  a  responsibility  that  properly  devolves  upon  the  direc- 
tors, there  can,  it  is  thought,  be  no  possible  objection  in  the 
case  of  the  accounts  of  private  firms.  Moreover,  it  cannot  be 
denied  that  the  subject  is  at  all  times  one  upon  which  the 
auditor  should  have  definite  and  well-matured  opinions. 

The  form  of  accounts  to  be  submitted  by  public  service  cor- 
porations has  received  much  more  attention  than  the  form  of 
the  accounts  of  industrial  corporations.  This  is  due  in  part  to 
the  efficient  work  done  by  the  various  societies  and  associations 
of  accounting  officers,  such  as  the  Association  of  American 
Railway  Accounting  Officers  and  the  Street  Railway  Account- 
ants' Association,  which  devised  uniform  systems  of  accounting 
and  urged  their  adoption.  The  governmental  regulation  of 
railroads  and  public  utilities  which  necessitated  the  use  of  pre- 
scribed forms  of  report  has  also  been  a  factor.  Further- 
more, it  should  be  remembered  that  these  undertakings  lend 
themselves    more    readily    to    uniformity   of    statement   than 

208 


OBJECT  OF  REVENUE  ACCOUNTS.  209 

industrial  enterprises  wherein  the  conditions  existing,  even 
in  the  case  of  concerns  in  the  same  line  of  business, 
are  frequently  so  dissimilar.  The  American  Association  of 
Public  Accountants  has  also  been  active  in  this  direction;  one 
committee  has  submitted  forms  for  Standard  Schedules  and 
Uniform  Reports  upon  Municipal  and  Public  Service  Corpora- 
tions, w^hile  during  the  New^  York  insurance  investigation  of 
several  years  ago  a  joint  committee  of  the  Association  and  the 
New  York  State  Society  of  Certified  Public  Accountants  pre- 
pared model  forms  for  the  reports  of  life  insurance  companies 
which  are  a  great  improvement  over  the  forms  in  use  by  the 
Insurance  Departments  of  the  various  States. 

With  regard  to  the  published  reports  of  industrial  corpora- 
tions great  divergence  of  form  still  obtains  and  some  of  them 
seem  to  be  prepared  with  the  thought  that  the  less  shown  the 
better,  otherwise  the  stockholder  may  really  learn  something 
about  the  operations  and  financial  condition  of  his  company. 
It  is  hoped,  however,  that  the  growing  custom  of  submitting 
the  accounts  to  Certified  Public  Accountants  for  audit  will 
result  in  considerable  improvement  in  this  respect,  and  that, 
while  it  is  not  to  be  expected  that  there  will  be  uniformity  of 
detail,  there  will  be  more  uniformity  as  to  principle  and  the 
essentials  which  such  reports  should  contain. 

In  Appendix  D  are  presented  a  number  of  forms  of  ac- 
counts which  have  been  gathered  from  different  sources  and 
which  will  indicate  what  has  been  accomplished  in  this  direc- 
tion. 

It  may  be  stated  at  the  outset  that  the  accounts  with  which 
it  is  now  proposed  to  deal  are  those  which  are  ordinarily  pub- 
lished as  "  the  audited  accounts  " — ^viz.,  the  Revenue  Account 
(or  its  equivalents)  and  the  Balance  Sheet. 

OBJECT  OF  REVENUE  ACCOUNTS. 

Taking  first  the  account  which  in  diflFerent  undertakings  is 
variously  called  the  trading  account,  the  manufacturing  ac- 
count, the  profit  and  loss  account,  and  the  revenue  account,  the 
first  point  to  be  considered  is  the  real  object  of  preparing  such 


210  AUDITING. 

an  account.     This  may  be  stated  to  be  for  the  purpose  of 
showing — 

First,  the  amount  of  business  done  in  each  of  the  vari- 
ous branches  in  which  business  is  carried  on ; 

Second,  the  amount  of  expenditure  in  each  of  the 
branches,  or  departments,  necessary  for  the  carrying  on 
of  that  business;  and, 

Third,  the  amount  of  surplus,  or  profit — or  loss,  as 
the  case  may  be — which  arises  from  the  carrying  on  of 
the  business. 

The  object  of  the  information  is  doubtless  primarily  to  ascer- 
tain the  amount  of  ultimate  profit  or  loss,  but  beyond  this 
there  is  also  the  further  object — which,  perhaps,  is  only  fully 
appreciated  by  those  skilled  in  accounts — of  comparing  the  cor- 
responding items  of  various  periods,  with  a  view  to  ascertain 
how  income  may  be  increased  and  expenditure  reduced,  or, 
on  the  other  hand  (so  far  as  possible),  why  income  has  become 
reduced  and  why  expenditure  has  increased. 

It  will  thus  be  seen  that  the  efficiency  of  this  account  depends 
very  materially  upon  the  skill  with  which  the  income  and 
expenditure  have  been  distributed  over  the  various  headings 
employed,  and  consequently  it  becomes  necessary  to  discuss  the 
nature  of  the  various  headings  under  which  the  items  of  this 
account  should  be  divided. 

It  goes  without  saying  that,  inasmuch  as  this  account  details 
the  summarized  result  of  the  transactions  recorded  in  the 
books,  its  exact  nature  will  very  materially  depend  upon  the 
precise  business  which  is  being  carried  on.  It  therefore  be- 
comes necessary  to  further  consider  the  subject  under  the 
headings  of  various  classes  of  business. 


COMMERCIAL  ACCOUNTS. 

Taking  first  commercial  concerns  (which  undoubtedly  rep- 
resent the  great  majority  of  the  undertakings  which  are  now 


COMMERCIAL   ACCOUNTS.  211 

being  considered),  it  will  be  found  that  the  transactions  con- 
sist in  the  buying  of  goods  and  the  selling  thereof,  either  in 
the  precise  form  in  which  they  were  purchased  (as  in  the  case 
of  traders),  or  in  an  altered  form  (as  in  the  case  of  manu- 
facturers) ;  in  both  cases  there  being  the  further  expenditure 
incidental  to  the  carrying  on  of  the  undertaking. 

ACCOUNTS  OF  TRADERS.— The  accounts  of  traders  are 
naturally  of  a  simpler  nature  than  those  which  require  to  be 
kept  by  manufacturers.  A  trader's  revenue  or  profit  and  loss 
account  should  show  clearly  at  least  three  things : 

I  St.  The  gross  business  or  turnover  during  the  period. 

2nd.  The  gross  profit  thereon  and  the  ratio  of  one  to  the 
other. 

3rd.  Whether  the  volume  of  business  has  been  large  enough 
to  produce  a  gross  profit  sufficient  to  provide  for  the  selling 
and  administrative  expenses  and  a  net  profit. 

It  would  be  very  difficult  to  find  an  exact  definition  of  the 
term  "  gross  profit,"  inasmuch  as  the  items  from  which  it  is  cal- 
culated will  be  found  to  vary  in  different  undertakings;  but 
seeing  that  the  whole  business  of  a  trader  is  based  upon  the 
calculation  of  a  fixed  percentage  of  gross  profit  upon  each 
different  class  of  goods  dealt  with,  it  necessarily  follows  that 
any  form  of  accounts  which  does  not  recognize  the  existence 
of  such  a  thing  as  "gross  profit"  fails  to  afford  the  trader  that 
assistance  which  he  is  entitled  to  look  for  from  his  accounts, 
and  consequently  to  a  very  great  extent  fails  to  justify  its 
existence. 

It  has  been  argued  by  many  experienced  accountants  that 
gross  profit  cannot  be  considered  to  arise  until  such  things 
as  rent  of  warehouse,  salaries  of  warehousemen,  &c.,  have 
been  debited  to  the  trading  account;  but  as  it  is  the  almost 
universal   custom   of  traders  to   reckon  their  percentage   of 


212  AUDITING. 

gross  profit  entirely  from  the  cost  price  of  their  goods  (al- 
though, as  a  matter  of  convenience,  they  actually  make  the  cal- 
culation backwards  from  their  selling  price)  it  would  seem 
that,  however  correct  it  may  be  in  theory,  it  is  in  practice 
nothing  more  than  pedantic  to  include  in  this  first  section  of 
the  account  anything  more  than  "  Sales  "  upon  the  credit  side, 
and  the  opening  "  Stock  "  plus  "  Purchases  "  and  minus  the 
closing  "  Stock  "  upon  the  debit.  It  is,  of  course,  quite  possi- 
ble to  argue  that  the  resultant  credit  balance  means  absolutely 
nothing  at  all;  but,  even  if  this  were  so,  the  fact  remains 
that  unless  the  account  be  so  prepared  it  is  impossible  to  see 
whether  the  aggregate  transactions  of  a  period  actually  result 
in  the  percentage  of  gross  profit  which  the  trader  had  been 
calculating  upon  throughout  that  period;  and,  therefore, 
whether  it  is  thought  best  to  call  the  balance  of  this  first  section 
*'  Gross  Profit,"  or  to  employ  the  indefinite  term  "  Balance," 
the  overwhelming  weight  of  advantage  lies  in  bringing  the 
account — in  this  respect  at  least — into  accord  with  the  custom 
of  every  trader,  and  so  enabling  him  to  ascertain  whether 
during  any  period  he  has  actually  achieved  the  results  which  he 
anticipated. 

In  the  second  section  of  the  revenue  account  may  be  in- 
cluded all  items  of  income  and  expenditure  relating  to  the 
business.  These  expenses  should  be  grouped  in  convenient 
subsections,  so  that  the  effect  of  each  group  upon  the  whole 
may  be  readily  perceived.  This  is  useful  both  for  the  pur- 
pose of  seeing  how  far  the  net  profits  of  a  concern  have  been 
affected  by  purely  financial  reasons,  and  how  far  by  com- 
mercial reasons,  and  also  on  account  of  the  convenience  it 
affords  if  it  should  at  any  future  time  be  decided  to  convert  the 
venture  into  a  corporation. 

MANUFACTURERS'  ACCOUNTS.— Passing  on  to  the 
accounts  of  manufacturers,  it  is  first  necessary  to  subdivide 
this  heading  in  accordance  with  the  various  classes  of  business 
that  fall  heretmder.     There  is  first  of  all  the  class  of  manu- 


COMMERCIAL   ACCOUNTS.  21 3 

facturers  but  slightly  removed  from  the  trader — ^that  is  to 
say,  the  manufacturer  who  does  not  require  to  sink  a  large 
proportion  of  his  capital  in  expensive  plant  and  machinery, 
the  most  typical  examples  of  which  are,  perhaps,  that  of  the 
small  manufacturing  jeweler  and  the  small  manufacturing 
tailor — both  of  whom,  by  the  way,  are  fast  dying  out.  In 
this  class,  as  with  traders  pure  and  simple,  the  selling  price  is 
based  upon  a  percentage  of  so-called  "  Gross  Profit,"  the  out- 
lay in  this  case  being  the  cost  of  materials,  together  with  the 
wages  spent  upon  manufacturing;  and,  therefore,  although 
the  method  is  clearly  indefensible  from  a  theoretical  point  of 
view,  the  division  between  the  first  and  second  sections  may 
conveniently  be  drawn  exactly  where  it  is  drawn  by  the  manu- 
facturer himself  in  his  mental  calculations.  Those  who  wish 
to  have  their  accounts  as  complete  as  possible  may  prefer  in 
addition  to  make  a  further  subdivision  of  this  account  in  the 
second  section,  separating  the  expenses  of  manufacturing 
(such  as  rent  of  factory,  wages  paid  for  supervision  of  work- 
ers, depreciation  of  plant,  &c.)  from  those  expenses  which 
relate  more  particularly  to  the  storing  of  goods  and  the  sell- 
ing thereof;  but  inasmuch  as  the  balance  shown  by  this  break 
would  correspond  with  nothing  in  the  mind  of  the  manufac- 
turer it  appears  to  be  superfluous,  and  it  will  probably  be 
thought  sufficient  to  merely  show  separate  totals  for  these 
classes  of  expenditure  in  the  same  section. 

The  manufacturers  belonging  to  the  next  class  are  those 
whose  transactions  consist  in  the  manufacture  of  one  or  more 
classes  of  goods  involving  expensive  plant,  which  goods  are 
first  manufactured  and  then  warehoused  before  being  sold. 
These  undertakings  are  naturally  upon  a  much  larger  scale 
than  those  which  have  just  been  considered,  and  consequently 
it  will  be  found  that  the  accounts  are,  as  a  rule,  more  scien- 
tifically kept,  and  the  method  of  costing  more  complete. 

The  first  section  of  the  account  thus  becomes  divided  into 
two  parts  upon  what  may  be  called  parallel  lines,  viz : — 


214  AUDITING. 

The  manufacturing  account,  which  deals  with  the  con- 
version of  raw  material  into  manufactured  articles,  and 
shows  the  cost  of  manufacture  and  the  stock  of  raw. 
materials  on  hand. 

The  trading  account  proper,  drawn  upon  the  same 
lines  as  the  first  section  of  a  trader's  profit  and  loss  ac- 
count. 

The  second  section  of  the  account  does  not  present  any  new 
features  that  call  for  consideration. 

The  expenses  included  in  the  manufacturing  account  will 
(as  a  rule)  be  those  which  are  dealt  with  in  the  cost  accounts, 
and  those  only.  It  is  quite  likely,  therefore,  that  factory  ex- 
penses would  be  debited  to  the  manufacturing  account,  rather 
than  to  the  profit  and  loss  account,  although  the  effect  of  so 
doing  will  be  to  obscure  the  percentage  of  (so-called)  gross 
profit. 

CONTRACTORS'  ACCOUNTS.— The  next  class  of  man- 
ufacturers to  be  dealt  with  consists  of  those  that  may  con- 
veniently be  summarized  under  the  head  of  "  Contractors," 
f.  e.,  those  manufacturers  who  only  make  articles  which  have 
already  been  sold  for  an  agreed  price.  To  this  class  belong 
builders  and  many  engineers. 

It  is  in  this  class  as  much  as  anywhere  that  the  absolute 
necessity  of  proper  cost  accounts  is  so  evident.  Indeed,  all 
contractors'  accounts  may  be  regarded  as  incomplete  which  do 
not  provide,  in  addition  to  any  ordinary  profit  and  loss  account, 
a  "  Summary  of  Cost  Account,"  showing  the  same  results. 
This  being  done,  the  chief  interest  centres  round  the  cost  ac- 
count rather  than  the  profit  and  loss  account  itself,  and  there 
is  thus  less  necessity  for  the  latter  to  be  unduly  elaborate.  It 
is  therefore  usually  best  to  state  this  latter  account  in  one 
section  only. 

It  is,  perhaps,  unnecessary  to  add  that,  in  practice,  an  abso- 
lute agreement  between  the  profit  and  loss  account  and  the  sum- 


MINING  ACCOUNTS.  215 

mary  of  cost  account  is  hardly  to  be  expected ;  but  a  very  close 
approximation  must  be  arrived  at  before  either  can  be  safely 
relied  upon. 

STATISTICAL  INFORMATION.— In  connection  with 
all  the  preceding  accounts  it  will  usually  be  found  of  the  very 
greatest  assistance  to  add  statistical  columns,  for  the  purpose 
of  showing  the  relation  which  each  item  bears  to  the  amount 
of  trade  done.  This  relation  will  usually  be  expressed  in  the 
form  of  a  percentage  on  the  amount  of  the  sales,  but  where 
the  business  deals  with  articles  of  a  uniform  or  similar  char- 
acter— as,  for  instance,  in  the  case  of  collieries,  brickyards,  and 
the  like — the  percentage  will  probably  be  based  upon  some 
quantity,  or  unit,  of  the  goods  dealt  in,  as  "  per  ton  of  coal " 
or  "  per  thousand  bricks,"  and  in  these  cases  it  is  usually 
thought  more  convenient  for  the  unit  to  be  the  production 
rather  than  the  sale. 

In  published  accounts  it  is  also  somewhat  usual,  and  very 
convenient,  to  pubHsh,  side  by  side  with  the  figures  for  the 
current  period,  those  for  the  next  preceding  period,  for  the 
purposes  of  comparison.  For  the  sake  of  clearness  the  figures 
for  the  current  period  appear  first,  and  sometimes  it  is  desir- 
able to  have  the  figures  of  the  preceding  period  appear  in  red 
ink  or  italics,  or  some  other  type  which  may  be  readily  distin- 
guished from  that  in  which  the  accounts  for  the  current  year 
or  period  are  printed. 

MINING  ACCOUNTS. 

Another  very  important  class  of  accounts,  which  can  hardly 
be  said  to  come  under  any  of  the  previous  headings,  is  that 
relating  to  mines.  These  accounts  are  best  dealt  with  in  two 
sections :  one  to  include  all  items  relating  to  the  actual  work- 
ing of  the  undertaking ;  and  the  other,  those  appertaining  more 
particularly  to  finance.  Cost  accounts  would  be  made  weekly 
or  monthly,  but  they  would  usually  form  no  part  of  the  an- 
nual accounts. 


2l6  AUDITING. 

"NET  PROFIT." 

This  is,  perhaps,  the  proper  place  to  offer  a  protest  against 
the  method  adopted  by  many  companies  of  stating  in  their 
published  accounts  a  so-called  "  Net  Profit,"  out  of  which  it 
is  proposed  to  set  aside  a  certain  sum  for  depreciation.  A  true 
net  profit  can  only  be  arrived  at  after  charging  up  all  expenses 
— including,  of  course,'  depreciation,  interest  on  bonds,  &c.,  &c. 

BALANCE  SHEETS. 

Turning  now  to  the  question  of  balance  sheets,  perhaps 
the  first  point  to  be  disposed  of  is  the  question  "  What  arc 
assets  ?  " 

WHAT  ARE  ASSETS  ? 

Going  back  to  first  principles,  it  must  be  admitted  that  an 
asset  may  be  fairly  defined  as  "  an  expenditure  upon  a  re- 
munerative object,"  and,  indeed,  it  may  be  taken  as  the  test 
of  whether  any  particular  expenditure  is  an  asset  or  a  loss  to 
inquire  whether  as  a  matter  of  fact  such  expenditure  was-^ 
looking  back  upon  it — worth  the  amount  expended  upon  it. 
This  applies  whether  the  expenditure  is  in  the  nature  of  capital 
spent  in  the  purchase  or  construction  of  any  particular  prop- 
erty, or  in  the  purchase  of  property  or  labor  which  was  sub- 
sequently sold  to  another.  In  the  former  case,  if — looking 
back  upon  it — it  is  considered  that  if  the  opportunity  of  making 
the  investment  a  second  time  should  again  arise  it  might  rea- 
sonably be  made  upon  the  same  terms,  it  may  fairly  be  said  that 
there  is  value  for  the  original  outlay;  and  in  the  latter  case, 
if — looking  back  upon  it  in  the  light  of  present  experience — one 
would  again  sell  upon  trust  to  any  particular  individual  prop- 
erty upon  which  time  or  money  had  been  expended,  it  may 
fairly  be  said  that  value  is  still  remaining  for  the  amount  with 
which  it  at  present  stands  charged.  If,  on  the  other  hand,  it 
appears  that  the  value  remaining  for  such  expenditure  is  less 
than  the  original  amount  of  such  expenditure,  it  is  obvious  that, 
as  a  matter  of  fact,  depreciation  has  occurred. 


FORM  OF  BALANCE  SHEET.  2I7 

NECESSITY  FOR  DEPRECIATION. 

It  appears  doubtful  as  to  whether  any  of  our  laws  compel 
a  company  to  make  provision  for  depreciation  before  declaring 
dividends  out  of  its  earnings,  although  our  courts  will  probably 
be  called  upon  to  pass  on  this  question  in  the  near  future,  and 
if  the  principle  involved  is  clearly  stated,  it  is  more  than  likely 
that  it  will  be  judicially  determined  that  depreciation  is  a 
charge  against  profits.  It  is  unfortunate  that  the  question  of 
depreciation  was  not  raised  in  the  American  Malting  case. 
It  was  not  necessary,  however,  as  the  other  losses  were  suffi- 
cient to  offset  all  of  the  dividends  paid. 

The  question  of  depreciation  is,  therefore,  rather  one  of 
prudence,  or  internal  administration,  than  of  legal  compul- 
sion. 

METHOD  OF  PROVIDING  DEPRECIATION.— Many 
companies  deem  it  undesirable  to  deduct  the  depreciation  from 
the  cost  shown  in  the  capital  expenditure  account,  and  the 
method  adopted  is  to  accumulate  the  amount  set  aside  from 
time  to  time  upon  a  depreciation  (fund)  account,  or  a  reserve 
for  repairs  and  renewals  account,  which  is  included  as  a  lia- 
bility in  the  general  balance  sheet  (although  not  necessarily 
stated  separately).  On  the  other  hand,  the  more  usual  course 
is  to  deduct  the  amount  written  off  for  depreciation  from  the 
amount  at  which  the  value  of  the  asset  is  stated,  and  this 
whether  the  asset  account  and  depreciation  account  are  kept 
separate  in  the  ledger  or  not. 

FORM  OF  BALANCE  SHEET. 

The  various  items  which  are  ordinarily  found  upon  a  bal- 
ance sheet  will  now  be  dealt  with  in  order,  and  the  best  form  of 
wording  under  various  circumstances  considered. 

The  form  generally  accepted  in  England  places  the  liabilities 
upon  the  left-hand  side  and  the  assets  upon  the  right-hand  side, 
commencing  upon  both  sides  with  the  most  permanent  items, 


2l8  AUDITING. 

and  leaving  those  which  are  most  constantly  varying  to  the 
last.  This  is,  in  fact,  the  form  provided  in  their  Companies 
Act  of  1862. 

In  the  United  States,  however,  while  statutory  forms  prac- 
tically do  not  exist,  yet  the  practice  of  placing  the  assets  on 
the  right  and  liabilities  on  the  left  is  without  a  single  known 
exception  reversed,  and  this  may  be  said  to  have  the  effect 
of  law  with  us. 

Under  the  Italian  system  of  bookkeeping,  which  is  still  prac- 
ticed in  some  old-fashioned  merchants'  houses  it  is  the  custom 
at  every  period  of  balancing,  after  the  nominal  accounts  have 
been  closed,  to  transfer  the  balances  of  the  real  and  personal 
accounts  into  one  account,  usually  called  in  England  and  in  the 
United  States  the  "  Balance  Account,"  and  in  France  the 
^'Balance  de  Sortir,"  or  "  Closing  Balance."  Under  such  cir- 
cumstances, the  ledger  would  be  actually  closed  (which,  in 
fact,  is  never  the  case  under  the  ordinary  system),  and  the 
Balance  Account  so  raised  would  practically  be  a  detailed 
balance  sheet,  with  the  assets  upon  the  Dr.  and  the  liabilities 
upon  the  Cr.  side,  as  shown  in  all  of  our  balance  sheets. 

It  may  be  that  assets  always  appearing  on  the  left-hand 
side  of  the  ledger  explains  our  present  system,  which  also  seems 
to  correspond  with  the  Italian  method  referred  to,  but  in  view 
of  the  fact  that  our  present  practice  is  settled,  and  inasmuch 
as  there  does  not  seem  to  have  been  a  single  objection  raised 
on  account  of  its  being  unscientific,  or  for  any  other  reason, 
it  would  seem  unnecessary  to  discuss  the  reasons  which  must 
have  governed  those  responsible  for  stating  our  balance  sheets 
diametrically  different  from  the  English  method. 

We  shall,  therefore,  first  treat  of  the  asset  or  left-hand  side 
of  the  balance  sheet. 

It  might  be  well,  however,  before  going  further,  to  mention 
that  probably  nine  out  of  ten  published  balance  sheets  include 
items  under  "  Assets  "  and  "  Liabilities  "  which  certainly  are 


FORM   OF   BALANCE   SHEET.  219 

not  either  one.  This  is  to  be  deplored  because  professional 
auditors  are  looked  to  not  only  as  authorities  on  form,  but  also 
as  authorities  on  principle.  It  certainly  cannot  be  successfully 
contended  that  a  debit  balance  to  profit  and  loss,  or  a  deficit,  is 
an  asset  nor  per  contra  is  a  credit  balance  to  Profit  and  Loss, 
or  a  surplus,  a  liability.  Furthermore  the  share  capital  of  a 
corporation  is  no  more  of  a  liability  than  is  partners'  capital  in 
a  partnership. 

It  is  only  possible  to  justify  the  inclusion  of  any  item  in  a 
balance  sheet,  provided — at  that  time  at  least — it  is  reasonable 
to  treat  it  as  an  asset,  or  a  liability,  as  the  case  may  be. 

Inasmuch  as  these  headings  are  always  attached  to  balance 
sheets,  the  incongruity  of  non-permissible  items  is  emphasized, 
but  it  does  not  seem  to  have  any  effect.  It  may  be  urged  that 
this  course  is  necessary  for  the  sake  of  convenience,  and  that 
in  order  to  intelligently  group  the  right  and  left-hand  sides  the 
footings  must  be  equal.  This  reasoning  is  so  opposed  to  the 
principles  of  accountancy  that  it  hardly  merits  an  answer.  Per- 
haps the  best  illustration  of  this  point  is  found  in  the  case  of  a 
professional  auditor  who  is  asked  to  address  a  body  of  account- 
ant students  on  the  topic,  let  us  say,  'What  are  Assets  and 
Liabilities  ?  "  It  is  not  supposed  for  a  moment  that  he  will 
state  that  actual  net  losses  of  operation,  represented  by  a  debit 
balance  to  profit  and  loss,  should  be  carried  on  a  balance  sheet 
under  the  heading  of  assets,  nor  will  he  explain  that  accum- 
ulated and  unapportioned  profits  are  properly  stated  under 
"  Liabilities."  He  may  take  a  middle  course  with  regard  to  the 
share  capital  which,  while  not  a  liability  so  far  as  creditors 
are  concerned,  may  be  so  termed  with  respect  to  the  com- 
pany's position  to  its  stockholders. 

Imagine,  then,  the  same  students  reading  a  published  report 
containing  a  balance  sheet  prepared  by  the  same  professional 
auditor  containing  the  items  just  mentioned  stated  boldly  as 
assets  or  liabilities  as  the  case  might  be.  And  all  for  the  sake 
of  convenience ! 


220  AUDITING. 

THE  ASSET  SIDE. 

The  order  in  which  assets  should  be  stated  on  a  balance 
sheet  is  a  somewhat  disputed  point  among  American  ac- 
countants. It  is  the  opinion  of  many  leading  practitioners 
that  assets  should  be  stated  in  the  order  of  their  convertibility ; 
that  is,  cash  would  be  first,  followed  by  accounts  and  bills  re- 
ceivable, stock  and  all  other  "  quick  "  assets,  while  the  fixed 
assets  would  be  last.  One  important  point  urged  in  favor  of 
this  order  is  that  a  balance  sheet  should  be  framed,  so  far  as 
possible,  for  the  convenient  use  of  those  for  whom  it  is  in- 
tended. The  majority  of  balance  sheets  are  submitted  at  one 
time  or  another  to  bankers,  who  almost  invariably  look  first  for 
"  quick  "  assets  on  one  side,  and  the  accounts  and  bills  payable 
on  the  other. 

The  reverse  order  is  becoming  quite  general,  however,  in 
stating  the  accounts  of  railroads  and  large  industrial  enter- 
prises. The  practice  as  to  this  point  is  not  yet  definitely  settled, 
and  we  shall,  therefore,  for  convenience  consider  the  various 
items  in  the  same  order  as  they  appear  in  "  Table  A"  of  the 
English  Companies  Act  already  referred  to. 

FIXED  ASSETS. — In  the  majority  of  cases  the  titles  of  the 
accounts  which  represent  fixed  or  capital  assets  are  not  illumin- 
ating, and  it  is  becoming  more  and  more  frequent  in  large  cor- 
porations to  include  practically  all  of  their  assets  of  this  char- 
acter under  one  caption,  such  as  "  Plant,"  and  it  accordingly 
becomes  almost  impossible  to  gain  an  intelligent  idea  of  their 
resources. 

Where  it  is  possible  to  do  so,  the  fixed  assets  should  be 
divided  into  land,  buildings,  machinery,  patents,  goodwill,  &c., 
and  it  should  be  clearly  shown  whether  they  are  carried  at  cost 
or  whether  proper  depreciation  has  been  allowed. 

The  chief  difficulties  in  the  way  of  preparing  such  a  state- 
ment are,  first,  the  over-valuation  of  assets  to  balance  large 
capital  stock  issues,  and  the  consequent  temptation  to  hide  the 
real  facts  by  lumping  all  the  fixed  assets;  and,  secondly,  the 


THE  ASSET  SIDE.  221 

large  number  of  cases  of  holding  companies  and  consolidations 
where  the  fixed  assets  have  passed  through  so  many  stages 
that  their  original  identity  is  lost. 

Professional  auditors  are  not  the  only  ones  who  criticise 
such  reports,  as  is  evidenced  by  the  numerous  comments  on  one 
of  the  annual  balance  sheets  of  the  Amalgamated  Copper 
Company. 

The  following  extract  from  one  of  New  York's  leading 
dailies  is  representative  of  the  views  generally  expressed : — 

"An  unverified  balance  sheet  is  not  very  satisfying.  Of  course, 
there  was  the  usual  accountants'  certificate  of  the  correctness  of  the 
accounts,  and  no  disparagement  of  that  is  intended.  The  point  is  that 
something  different  was  called  for  as  a  basis  for  any  conviction  regard- 
ing present  or  future  worth.  There  was,  for  instance,  an  entry  in  a 
single  line  of  investments  of  $154,281,303,  with  no  list  of  them,  and  no 
expert  appraisal  of  the  physical  condition  of  the  properties.  The  sur- 
plus is  almost  wholly  balanced  by  loans  to  a  subsidiary  company,  the 
cash  on  hand  is  only  $2,756,759,  and  if  there  has  been  any  writing  off 
upon  account  of  exhaustion  of  ore  through  payment  of  dividends  aggre- 
gating $29,100,000,  it  is  well  concealed." 

CURRENT  OR  "  QUICK  "  ASSETS.— Next  in  order  we 
find  Stock-in-Trade.  This  point  was  exhaustively  covered  in 
the  paper  of  A.  Lowes  Dickinson,  F.C.A.,  C.P.A.,  which  was 
read  at  the  St.  Louis  Congress  of  Accountants,  where  he 
said : — 

"  Stocks  on  Hand. — Perhaps  one  of  the  most  difficult  questions 
which  accountants  have  to  decide  is  the  correct  enumeration  and  valu- 
ation of  stocks  on  hand.  The  theory  governing  the  valuation  of  this 
asset  is  that,  inasmuch  as  no  profits  can  be  realized  until  the  goods  are 
actually  sold,  it  is  not  safe  to  take  credit  for  any  profit  thereon  until  a 
sale  has  been  effected;  that,  therefore,  it  should  be  carried  forward  at 
the  exact  cost,  and  no  profit  thereon  brought  into  the  accounts  of  the 
fiscal  period.  On  the  other  hand,  it  may  be  found  that  the  prices  both 
of  the  raw  materials  and  the  finished  product  have  at  the  close  of  the 
fiscal  year  fallen  below  their  cost,  and  while  it  is  impossible  to  say  until 
the  goods  have  been  sold  whether  any  loss  will  ultimately  be  made 
thereon,  at  any  rate  there  is  a  possibility  thereof.  It  is,  therefore,  con- 
servative to  set  aside  a  sufficient  reserve  out  of  profits  which  have  been 
realized  on  goods  already  sold  to  provide  for  the  accruing  loss  on  those 


222  AUDITING. 

which  remain  in  hand.  Hence  the  general  rule  for  valuation  of  stocks 
on  hand,  namely,  '  cost  or  market,  whichever  is  the  lower,'  has  been 
evolved,  and  is  adopted  by  the  most  conservative  commercial  institu- 
tions. Unfortunately,  in  practice,  many  concerns  are  unable  to  ascer- 
tain the  cost  of  their  various  products,  with  the  result  that  their  stock 
valuations  are  based  entirely  on  estimates  of  costs  made  with  more  or 
less  accuracy.  There  does  not  appear  to  be  any  legal  obligation  on  a 
corporation  to  adopt  any  particular  basis,  provided  that  the  price 
adopted  is  not  in  excess  of  that  ultimately  realized  after  deduction  of 
any  subsequent  cost  of  completion,  storage  and  sale;  but  the  absence 
of  approximately  exact  knowledge  as  to  the  cost  frequently  leads  to 
disappointment,  both  to  the  directors  and  stockholders,  and  even  to 
serious  financial  loss.  It  is  obvious  that  a  constantly  changing  basis  of 
cost  must  lead  to  serious  inequalities  in  the  profits  shown  between  one 
period  and  another,  but  it  is  not  equally  obvious  to  the  commercial 
community  that  an  erroneous  basis  of  valuation  consistently  adopted 
year  after  year,  even  if  that  basis  be  a  conservative  one  and  really 
below  true  cost,  may  result  in  large  and  unexpected  discrepancies  be- 
tween the  profits  shown  in  different  periods.  For  instance,  if  stocks  be 
valued  on  a  basis  exceeding  cost  and  the  trade,  and  consequently  the 
materials  and  products  on  hand  increase  very  rapidly  for  one  or  more 
years,  the  profits  during  those  years  of  increase  will  be  abnormally 
inflated;  but  when  the  trade  settles  down  to  a  comparatively  steady 
turn-over,  there  will  be  a  considerable  drop  in  the  profits  as  compared 
with  the  preceding  year  on  the  same  amount  of  business  done — a  drop 
which  the  management,  as  a  rule,  will  be  unable  to  account  for  until  an 
investigation  by  the  public  accountant  discloses  the  true  cause.  On  the 
other  hand,  if  the  stocks  be  conservatively  valued  considerably  below 
cost,  the  profits  of  a  year  in  which  a  small  quantity  of  goods  is  carried 
over  at  the  close  of  the  year  in  comparison  with  the  beginning  will  be 
inflated  as  compared  with  a  succeeding  year,  when  an  opposite  condi- 
tion prevailed,  although  the  sales  and  profit  thereon  may  have  been  the 
same  in  both  years ;  thus  entirely  upsetting  all  the  calculations  and  esti- 
mates of  the  managers.  The  essentials,  therefore,  for  ascertaining  cor- 
rect profits  so  far  as  stocks  on  hand  are  concerned  are : 

(a)  An  accurate  enumeration  of  the  quantities  on  hand. 

(b)  An  accurate  ascertainment  of  the  actual  cost  of  the  different 

manufactured  articles,  either  completed  or  in  progress. 

(r)  A  specific  reduction  in  the  prices  of  raw  materials  of  the 
amount  by  which  the  market  valuations  at  the  close  of  the 
fiscal  period  fell  short  of  the  cost. 

(d)  A  proper  provision  for  all  stock  which  is  old  or  depreciated, 
or  for  any  reason  likely  to  be  unsaleable. 


THE  ASSET   SIDE.  223 

"  The  more  exactly  these  different  elements  are  ascertained,  the  more 
accurate  will  be  the  resulting  statements  of  profits,  and  if  the  special 
reserves  be  made  separately,  it  will  be  an  easy  matter  to  compare  use- 
fully one  period  with  another. 

"Finally,  it  should  be  noted  that  it  is  not  essential,  and,  in  fact,  it 
will  frequently  be  incorrect,  to  value  materials  and  products  on  hand 
at  the  end  of  the  fiscal  period  upon  the  same  price  basis  as  at  the  com- 
mencement of  that  period;  all  that  is  necessary  or  proper  is  that  the 
basis  of  valuation — that  is  to  say,  the  principles  on  which  the  values  are 
arrived  at — should  be  the  same  at  the  beginning  and  end)  of  the 
period,  the  actual  prices  usually  varying  from  one  year  to  another." 

Next  come  "DEBTS  OWING  TO  THE  COMPANY," 
which  are  grouped  under  headings  as  follows : — 

Debts  considered  good,  for  which  the  company  holds  notes 
or  other  securities. 

Debts  considered  good,   for  which  the  company  holds  no 
security. 

Debts  considered  doubtful  and  bad. 

It  is  also  provided  that  ".any  debt  due  from  a  director  or 
any  other  officer  of  the  company  is  to  be  separately  stated." 

It  is  not  usually  considered  desirable  to  separately  state  the 
amount  of  the  doubtful  and  bad  debts,  but  the  provision  for 
the  separate  statement  of  any  debt  due  from  a  director  or 
other  officer  is  one  that  should  not  be  lost  sight  of ;  doubtless, 
it  is  not  intended  to  apply  in  the  case  of  debts  for  small 
amounts  in  the  regular  course  of  business,  but  cases  will 
readily  occur  to  the  reader  in  connection  with  some  recent 
failures  where  the  compliance  with  this  provision  might  have 
materially  affected  the  course  of  events. 

If  such  a  rule  had  been  enforced  in  recent  years  with  re- 
spect to  loans  to  directors  of  national  banks,  many  millions  of 
dollars  of  depositors'  money  would  have  been  saved. 

The  next  item  on  the  Balance  Sheet  is  INVESTMENTS, 
which  should  be  stated  in  some  detail,  and  if  the  investments 


224  AUDITING, 

are  on  account  of  reserve  fund  account  or  sinking  fund  ac- 
count, the  circumstance  should  be  clearly  stated. 

Mr.  Dickinson's  paper  also  dealt  with  this  caption  in  some 
detail,  and  his  entire  comment  is  reproduced : — 

"Marketable  Investments. — The  term  marketable  investments  is 
intended  to  include  only  such  investments  as  are  part  of  the  circulating 
as  distinct  from  the  fixed  assets.  The  latter  class  of  investments  may 
be  defined  as  those  which  cannot  be  disposed  of  without  affecting  the 
operations,  for  the  reason  that  the  ownership  thereof  in  a  permanent 
form  is  necessary,  however  remotely,  to  the  business  which  the  cor- 
poration is  carrying  on.  Their  valuation  would  be  governed  by  the 
same  principles  as  have  been  outlined  above  for  other  fixed  assets. 

Marketable  investments,  on  the  other  hand,  may  be  either: 

(a)  The  stock  in  trade  of  the  corporation,  or 

(&)  The  investment  of  surplus  cash  held!  in  this  form  until  re- 
quired for  ordinary  operating  purposes,  or 

(c)  The  investment  of  a  reserve  or  other  special  fund. 

"  In  case  (a)  the  rule  of  cost  or  market  value,  whichever  is  the  lower, 
applied  to  each  individual  investment,  and  not  to  the  group  as  a  whole, 
is  undoubtedly  the  most  conservative.  That  is  to  say,  no  profit  could 
be  taken  up  on  any  investment  until  it  is  sold,  but  on  the  other  hand, 
where  the  value  has  clearly  fallen,  some  provision  should  be  made 
therefor.  Where,  however,  the  investments  all  have  a  definitely  ascer- 
tainable market  value  at  any  time,  it  is,  perhaps,  fair  and  reasonable  to 
allow  a  fall  in  value  of  some  individual  investments  to  be  set  off  against 
a  rise  in  value  of  others,  provided  that  the  aggregate  valuation  is  not 
above  original  cost  or  market  value,  whichever  is  the  lower. 

"In  case  (b)  the  usual  custom  is  to  value  at  the  mean  market  price 
on  the  last  day  of  the  fiscal  period  for  the  reason  that  the  investments 
represent  the  equivalent  of  cash,  and  should,  therefore,  be  maintained  at 
their  cash  value  in  the  balance  sheet. 

"In  case  (c)  any  profit  or  loss,  either  realized  or  estimated,  would 
be  a  credit  or  charge  to  that  fund,  and  not  to  the  profit  and  loss 
account.  But  in  the  balance  sheet  such  investments  should  either  be 
clearly  stated  as  maintained  at  cost  or  preferably  be  adjusted  each 
year  to  the  aggregate  market  value  if  below  cost. 

"Another  method  of  dealing  with  the  fluctuations  of  marketable  in- 
vestments of  classes  (b)  and  (c)  is  to  create  an  investment  fluctuation 
reserve,  either  out  of  estimated  or  realized  profits  on  investments,  or  by 


THE  ASSET  SIDE.  225 

a  charge  to  profit  and  loss  of  such  an  amount  as  may  be  necessary  to 
prevent  this  reserve  from  showing  a  debit  balance,  and  by  charges  or 
credits  to  this  reserve  to  maintain  the  asset  at  market  value." 

The  corporations  in  whose  balance  sheets  marketable  invest- 
ments play  a  leading  part  are  insurance  companies,  banks 
(more  particularly  savings  banks)  and  trust  compaines.  In 
all  states,  so  far  as  is  knov^n,  the  solvency  of  insurance  com- 
panies is  tested  by  the  sufficiency  of  the  assets  (valuing  stocks 
and  bonds  at  the  market  prices)  to  meet  the  present  value  of 
policy  contracts  in  force  and  sundry  other  liabilities.  Owing 
to  the  abnormal  decline  in  the  market  values  of  securities  in 
the  fall  of  1907  the  statements  of  almost  all  the  life  insurance 
companies  at  December  31,  1907,  showed  a  startling  decrease 
in  surplus  as  compared  with  the  close  of  the  preceding  year. 
This  shrinkage  attracted  considerable  attention,  and  as  the  cor- 
porate bonds  owned  (the  fall  in  whose  market  quotations  was 
largely  responsible  therefor)  were  yielding  the  same  rate  of 
income  as  when  purchased,  and  as  there  was  no  serious  ques- 
tion as  to  the  security  of  the  principal  of  most  of  them, 
emphasis  was  given  to  the  question  of  whether  the  basis  of  so 
called  market  value  was  not  an  erroneous  one. 

Mr.  John  Tatlock,  then  President  of  the  Washington  Life 
Insurance  Company,  discussed  the  matter  very  fully  in  a  paper 
"  On  the  Proper  Method  of  Valuation  of  Fixed  Term  Securities 
Owned  by  Life  Insurance  Companies  "  which  was  read  at  a 
meeting  of  the  Association  of  Life  Insurance  Presidents.  The 
following  paragraphs  are  quoted  therefrom: 

"As  is  well  known,  the  current  practice  adopted  in  the  valuation  of 
bonds  is  to  allow  values  therefor  which  represent  the  actual  prices  at 
which  a  few  bonds  have  changed  hands  on,  or  as  near  thereto  as  may 
be,  the  date  of  accounting.  In  the  case  of  bonds  which  have  a  wide  and 
active  market  the  necessary  information  is  supplied  by  the  record  of 
public  transactions;  for  securities  which  appear  less  frequently  in  actual 
transactions  information  is  sought  from  dealers  concerned  in  such  trans- 
actions, the  resulting  values  being  based  thereby  more  or  less  upon  indi- 
vidual opinion  and  the  possible  market  available  to  the  individual 
dealer;  and  bonds  which,  on  account  of  the  extreme  infrequency  of 


226  AUDITING. 

transactions  therein,  constitute  a  third  and  distinctive  class,  are  oft-' 
times  credited  at  amounts  which  aptly  illustrate  the  force  of  a  recently- 
resurrected  and  adapted  epigram  to  the  effect  that  'Value  is  a  state  of 
mind.' 

"  In  seeking  to  establish  the  reasons  for  making  objection  to  the  prac- 
tice of  valuing  bonds  at  market  values,  it  becomes  proper  to  look  into 
the  cause,  or  causes,  of  market  fluctuations  of  the  class  of  securities 
now  under  review.  Passing  over  minor  considerations,  it  may  be  stated 
that  in  general  these  fluctuations  depend  upon  and  vary  with  the  mar- 
ket rate  of  interest,  or  the  measure  of  the  demand  for  money  for  use 
in  the  customary  channels  of  trade  and  commerce.  This  fact  empha- 
sizes a  strikingly  anomalous  condition  in  the  accounting  methods  of 
life  companies.  Liabilities  are  calculated  and  determined  on  the  assump- 
tion that  a  fixed  rate  of  interest  is  to  be  earned  on  the  assets  held  to 
offset  these  liabilities  during  the  period  of  continuance  of  the  contracts 
for  which  the  liabilities  are  set  up.  In  practice  the  offsetting  assets  are 
periodically  valued  at  varying  rates  of  interest  which,  at  times,  may  be, 
and  are,  set  so  high  that  the  assets  so  valued  fail  to  reach  in  amount  that 
necessary  to  cover  the  outstanding  Habilities.  In  other  words,  they  arc 
valued  to  provide,  for  instance,  for  a  return  of  6  per  cent.,  or  even  7 
per  cent,  when  they  were  acquired  to  give  a  return  of  from  3^/^  per 
cent,  to  4j^  per  cent,  to  cover  liabilities  whose  offsetting  assets  arc 
assumed  to  earn  3  per  cent,  or  4  per  cent.  From  what  source  is  de- 
rived the  bulk  of  the  funds  acquired  by  life  companies  which  necessi- 
tates investment?  It  consists  of  those  parts  of  premiums  which  con- 
stitute contributions  to  the  sinking  fund  known  as  the  '  reserve '  and 
in  the  calculation  of  which  no  such  anomaly,  as  indicated  above,  has, 
nor  possibly  could  have,  consideration.  It  has  been  stated  that  the 
practice  of  regarding  market  values  of  bonds  rests  upon  the  supposed 
analogy  between  liabilities  of  life  companies  and  those  of  banks  and 
similar  institutions.  In  point  of  fact  a  wide  difference  exists.  The 
liabilities  of  a  bank  are  practically  immediate ;  it  is  required,  from  the 
nature  of  its  business,  to  provide  for  possible  liquidation  within  a  short 
space  of  time.  The  liabilities  of  a  life  company,  on  the  other  hand,  are 
provided  by  contract  to  mature  over  a  period  of  a  long  term  of  years ; 
the  amount  of  Habilities  requiring  settlement  within  a  given  period,  or 
at  a  given  time,  can  be  determined  in  advance  with  a  high  degree  of 
accuracy,  and  good  management  can,  and  does,  provide  that  assets  to 
meet  maturing  obligations  are  in  hand  when  needed,  irrespective  of  the 
ups  and  downs  of  market  trading  in  such  assets  in  the  meantime.  It  is 
submitted  that  the  whole  question  of  solvency  of  a  life  company,  to  say 
nothing  of  its  function  as  a  profit-making  institution,  rests  directly 
upon  the  principles  and  practice  just  enunciated.    .    .    . 


THE  ASSET  SIDE.  22/ 

"  Criticism  and  the  expression  of  disapproval  of  an  existing  order  is 
rarely  justified  unless  followed  by  the  enunciation  of  a  remedy.  Bear- 
ing in  mind  that  securities  are  purchased  by  life  companies  for  perma- 
nent investment,  the  nature  and  occurrence  of  the  liabilities  for  which 
they  are  an  offset  and  the  complicated  questions  which  arise  in  connec- 
tion with  the  division  of  surplus — reference  to  which  will  again  be  made 
— it  is  submitted  that  the  method  of  valuing  bonds,  by  computing  their 
present  value  on  the  basis  of  the  effective,  or  actual,  rate  of  interest,  if 
held  to  maturity,  which  is  determined  by  the  prices  at  which  they  were 
originally  purchased,  meets  in  a  satisfactory  manner  all  the  conditions 
of  the  problem.  The  method  is  not  new  nor  original.  It  rests  upon 
fundamental  principles  of  interest  and  annuities,  and  has  been  used  for 
many  years  by  some  life  companies  and  many  other  financial  institutions 
in  fixing  the  book  values  of  bonds.  It  is  easy  of  application  by  means 
of  well-known  and  generally  adopted  tables.  It  contains  no  elements 
of  mystery  or  pure  assumption  and  involves  in  its  application  no  exer- 
cise of  independent  judgment.  In  considering  the  claims  for  attention 
to  this  method,  it  is  proper  to  note  the  nature  of  that  instrument  usually 
called  a  bond.  It  consists  of  an  obHgation  to  pay  a  fixed  sum  at  a  stated 
future  date,  which  sum  is  called  the  face  value  of  the  bond,  and  of  a 
series  of  obligations  to  pay  other  fixed  sums  at  the  end  of  periodical 
intervals  of  time,  usually  less  than  one  year,  the  dates  of  which  occur 
before  and  on  the  fixed  date  at  which  the  face  value  of  the  bond  is  due. 
If  the  rate  of  return  to  be  realized  on  a  bond  corresponcfc  in  its  pro- 
ceeds to  the  amount  of  the  obligation  due  at  the  end  of  each  periodical 
interval,  then  the  present  value  of  the  obligations  comprised  in  the  bond 
computed  at  such  rate  of  return,  will,  at  any  date  of  valuation,  be  equal 
to  the  face  value  of  the  bond.  Similarly,  if  the  rate  of  return  calls  for 
proceeds  which  exceed  the  amount  of  the  periodical  obligations,  then 
the  present  value  of  the  total  obligations  will,  at  any  time  before  the 
face  value  is  due,  be  less  than  such  face  value ;  if  the  rate  of  return  calls 
for  proceeds  which  are  less  than  the  amount  of  the  periodical  obliga- 
tions, then  the  present  value  of  the  total  obligations  will,  at  any  time 
before  the  face  value  is  due,  be  more  than  such  face  value. 

"  Bonds  are  rarely  purchased  at  par  or  face  value.  To  make  the 
amount  of  the  purchase  merge  into  the  amount  at  maturity  demands  an 
adjustment  of  accounts.  So  far  as  life  companies  are  concerned,  differ- 
ent methods  prevail.  Some,  at  date  of  purchase,  charge  off  a  premium 
or  credit  a  discount.  Others  perform  similar  operations  at  time  of 
maturity,  carrying  the  actual  cost  on  their  books  until  that  date ;  others 
distribute  the  difference  between  the  face  value  of  the  bond  and  the 
purchase  price  by  dividing  such  difference  into  instalments  in  propor- 
tion to  the  number  of  years  to  maturity,  charging  off  or  crediting  an 
instalment  each  year.     All  of  these  methods  are  open  to  criticism,  be- 


228  AUDITING. 

cause  at  any  date  of  valuation  the  results  attained  thereby  do  not  show 
actual  facts,  especially  those  pertaining  to  the  interest  account.  A  few 
companies  use  the  method  which  is  here  advocated,  the  only  method 
which,  for  certain  reasons,  is  believed  to  be  wholly  defensible  and 
worthy  of  general  adoption.    These  reasons  are  as  follows : 

"  First.  The  use  of  this  method  results  that  the  amount  of  the  invest- 
ments, as  carried  on  the  books  of  the  company,  is  at  maturity  exactly 
equal  to  the  amount  then  due. 

"  Second.  This  method  secures  the  debits  and  credits  to  interest 
account,  at  each  periodical  adjustment  of  the  book  value,  in  accordance 
with  the  effective  rate  of  interest,  on  the  basis  of  which  the  investment 
was  made. 

"  Third,  The  original  book  value  is  the  actual  cost  and,  at  any  date 
of  valuation  by  this  method,  the  book  value  represents  the  cost  of  such 
portions  of  the  obligations  as  have  not  then  matured. 

"Fourth.  This  method  avoids  the  necessity  of  making  arbitrary 
charges  or  credits  to  profit  and  loss  account. 

"  For  the  sake  of  completeness,  it  is  proper  to  remark  at  this  junc- 
ture that  the  statements  which  have  been  made  refer,  of  course,  to 
bonds  which  are  expected,  without  question,  to  be  paid  in  accordance 
with  their  terms.  As  to  others,  one  may  be  permitted  to  quote  as  fol- 
lows from  a  comprehensive  memorandum,  on  the  subject  of  valuation 
of  investments  in  general,  prepared  by  Mr.  Leon  O.  Fisher,  Auditor  of 
the  Equitable  Life  Assurance  Society  of  the  United  States: 

"  *  Special  provision  should  always  be  made  for  any  anticipated  losses 
of  principal,  through  the  insolvency  of  the  debtor,  but  such  provision 
should  be  made  by  creating  special  reserves  from  surplus,  rather  than 
by  writing  down  the  amortized  cost  value.' 

"While  it  may  be  said  that  attention,  more  or  less  public,  is  now 
directed  to  this  question  of  valuation  of  assets  by  reason  of  present 
financial  conditions,  too  much  emphasis  cannot  be  laid  upon  other  and 
far  more  important  considerations  which  demand  a  radical  change  in 
rules  heretofore  requiring  a  determination  of  market  values.  These 
are  to  be  found  in  the  course  of  legislation,  accomplished  and  prospec- 
tive. The  conditions  of  future  surplus  determination  and  division  are 
now  laid  down  by  statute,  and  compliance  with  these  conditions  can  only 
be  secured  by  pre-arranged  rules  and  methods.  Section  83  of  the  New 
York  Insurance  Law  reads,  in  part,  as  follows : 

"'Upon  the  thirty-first  day  of  December  of  each  year,  or  as  soon 
thereafter  as  may  be  practicable,  every  such  corporation  shall  well  and 


THE  ASSET  SIDE.  229 

truly  ascertain  the  surplus  earned  by  such  corporation  during  said  year. 
After  setting  aside  from  such  surplus  such  sums  as  may  be  required 
for  the  payment  of  authorized  dividends  upon  the  capital  stock,  if  any, 
and  such  sums  as  may  properly  be  held  for  account  of  existing  de- 
ferred dividend  policies,  and  for  a  contingency  reserve  not  in  excess  of 
the  amount  prescribed  in  this  article,  every  such  corporation  shall  ap- 
portion the  remaining  surplus  equitably  to  all  other  policies  entitled  to 
share  therein/ 

"It  will  be  noticed  that,  the  surplus  being  once  determined,  the 
deductions  vi^hich  may  be  made  therefrom  are  specifically  named.  No 
other  reservation  may  be  allowed.  In  a  year  in  which  a  large  advance 
in  market  values  has  obtained,  no  reserve  may  be  set  up,  out  of  the 
surplus  therein  earned,  as  an  offset  to  opposite  and  adverse  conditions 
which  may  obtain  a  year  later.  Under  the  market  value  theory,  paper 
profits  must  be  divided  and  paper  losses  must  be  charged  against  sur- 
plus otherwise  actually  earned." 

It  is  rather  curious  that  since  the  panic  of  1907  the  State  of 
New  York  has  enacted  a  law  requiring  savings  banks  (whose 
deposit  obligations  may  mature  on  comparatively  short  notice) 
to  value  their  fixed  term  securities  on  an  amortized  cost  or 
"  investment  value "  basis,  while  life  insurance  companies, 
(which  can  calculate  the  maturities  of  their  contract  obligations 
with  a  considerable  degree  of  certainty,)  are  still  required  to 
base  their  valuations  of  similar  securities  on  market  quota- 
tions. 

Last  upon  the  assets  side  is  the  item  of  CASH,  which  may 
be  separated  into — 

Amount  in  banks  on  deposit,  including  accrued  interest. 

Amount  in  hands  of  agents  or  at  branches. 

Amount  in  hand. 

CONTINGENT  ASSETS  if  of  sufficient  moment  should 
also  be  noted,  together  with  such  explanation  as  will  make 
clear  their  nature.  These  may  consist,  for  instance,  of  claims 
for  losses  sustained  by  breach  of  contract  which  can  only  be 
recovered  by  bringing  suit  in  the  courts  and  the  outcome  of 
which  action  may  be  too  uncertain  to  permit  of  the  claims  being 


230  AUDITING. 

definitely  treated  as  an  asset,  or  claims  against  the  government 
for  overcharges  in  duties  on  imports  due  to  improper  classifica- 
tion or  excessive  valuation. 

THE  LIABILITY  SIDE. 

Turning  now  to  the  liabilities,  it  is  convenient  to  deal  with 
these — as  with  the  assets — under  their  various  heads,  and  the 
order  also  follows  that  laid  down  by  "  Table  A "  of  the 
English  Companies  Act. 

CAPITAL. — Upon  the  liability  side  of  a  balance  sheet, 
framed  in  accordance  with  the  provisions  noted  above,  the 
most  prominent  item — in  the  case  of  a  corporation  at  least — 
is  the  stockholders'  capital,  which,  of  course,  can  only  be  in- 
creased beyond  its  original  limit,  or  reduced,  after  due  com- 
pliance with  impoirtant  legal  technicalities.  In  stating  the 
capital  account,  it  is  desirable  to  show  first  "  in  short "  the 
nominal  capital,  i  e.,  the  limit  sanctioned  by  the  Company's 
charter ;  secondly,  the  number  and  value  of  each  class  of  shares 
issued  and  the  amount  called  up  thereon,  from  which  should 
be  deducted  the  amount  of  calls  in  arrear,  stating  the  number 
of  shares  upon  which  such  calls  are  due.  In  France,  and  also 
in  South  America,  it  is  usual  to  state  the  full  amount  of  the 
capital  authorized  as  a  liability,  and  the  amount  unsubscribed 
as  an  asset ;  but  this  is  not  at  all  a  desirable  form  to  adopt,  as  it 
can  hardly  be  said  that  uncalled  or  unsubscribed  capital  is 
more  than  a  contingent  asset. 

BONDS. — Next  comes  the  amount  due  upon  bonds,  the 
amount  extended  being  full  amount  to  be  paid,  and  the  rate 
of  interest  and  year  of  maturity  should  be  mentioned. 

Mention  has  already  been  made  of  the  fact  that  at  one  time 
it  was  quite  customary  to  capitalize  discount  on  bond  issues. 
It  would,  of  course,  be  desirable  that  where  bond  discount  is 
carried  as  an  asset,  such  an  item  should  be  clearly  described, 
but,  so  far  as  is  known,  it  has  not  been  the  custom  to  state  the 
amount  of  such  discount  in  the  published  reports  of  any  com- 


THE  LIABILITY  SIDE.  23 1 

panics  except  in  cases  where  it  is  being  written  off  periodically. 
Fortunately,  the  recognition  of  the  true  nature  of  bond  dis- 
count is  becoming  more  general  and  it  is  to  be  hoped  that  this 
will  result  in  an  abandonment  of  the  practice  of  capitalizing  it 
even  in  the  case  of  private  corporations  which  are  not  specifi- 
cally forbidden  to  do  so  by  governmental  regulation. 

The  appropriate  place  for  premiums  received  upon  issues  of 
either  stock  or  bonds  is  in  a  special  reserve  account. 

MORTGAGES. — The  next  item  upon  the  balance  sheet  will 
be  the  amount  due  upon  mortgages,  other  than  those  covered 
by  bonds,  and  which  also  constitute  a  preferential  liability,  and, 
ordinarily  speaking,  are  practically  permanent.  The  rate  of 
interest  should  be  stated  here  also. 

OTHER  LIABILITIES.— Next  come  the  ordinary  liabili- 
ties of  the  company,  which,  according  to  "  Table  A,"  are  sepa- 
rated under  the  following  sub-headings: — 

(a)  Debts  for  which  notes  have  been  given. 

(b)  Debts  to  creditors  for  supplies  of  stock-in-trade  and 

other  articles. 

(c)  Debts  for  law  expenses. 

(d)  Debts  for  interest  upon  bonds  and  other  loans. 

(e)  Unclaimed  dividends. 

(/)  Debts  not  enumerated  above. 

Sometimes  the  item  ''(d)  Debts  for  interest  upon  bonds  and 
other  loans  "  are  shown  as  an  addition  to  the  loans  them- 
selves. Since  such  interest  would  be  covered  by  the  same 
security  by  which  the  principal  of  the  bonds  may  be  protected, 
this  may  be  the  proper  place  for  it  from  a  legal  point  of  view, 
but  inasmuch  as  interest  is  a  current  liability  as  distinguished 
from  the  principal,  which  is  a  funded  debt,  it  is  preferable  not 
to  combine  the  two. 


232  AUDITING. 

RESERVE  FUNDS.— The  next  item  upon  the  Hability  side 
is  for  "  Reserve  Fund,  showing  the  amount  set  aside  from 
profits  to  meet  contingencies."  This,  perhaps,  is  as  good  a 
definition  of  a  reserve  fund  as  has  been  offered,  and  although 
special  reserve  funds  may  be  created  for  the  purpose  of  pro- 
viding for  special  contingencies,  it  may  be  taken  as  an  axiom 
that  no  sum  which  is  not  set  aside  from  promts  can  properly  be 
called  a  reserve  fund.  Nevertheless,  under  the  heading  of 
"  Reserve  "  all  sorts  of  items  are  frequently  included  which 
under  no  possible  circumstances  can  be  considered  to  have 
been  set  aside  out  of  profits.  This,  perhaps,  raises  the  some- 
what large  question  as  to  what  are  actual  profits,  but  it  must 
at  least  be  admitted  that  the  term  "  Reserve  Fund  "  is  by  no 
means  applicable  to  all  the  following  (although  the  title  Re- 
serve Account  might  properly  be  used  in  connection  with 
each)  : 

(a)  A  sum  set  aside  to  meet  depreciation  of  property,  and 
to  provide  for  its  future  renewal.  This  is  a  charge  against 
profits,  rather  than  a  sum  set  aside  out  of  profits. 

(b)  A  sum  set  aside  for  the  purpose  of  equalizing  the 
charge  against  profit  and  loss  for  repairs  and  replacement  of 
machinery,  &c.  This,  also,  would  appear  to  be  a  charge 
against  profits. 

(c)  A  reserve  to  provide  for  loss  upon  bad  debts  or  de- 
preciation of  investments  would  likewise  appear  to  be  a  charge 
against  profits,  unless,  indeed,  the  amount  so  set  aside  was 
more  ample  than  the  circumstances  of  the  case  necessitated; 
and  in  this  case  it  would  probably  be  a  better  course  to  charge 
against  profits  what  might  be  considered  a  fair  reserve  for 
loss,  and  to  accumulate  any  further  reserve  that  might  be 
thought  prudent  in  the  form  of  a  reserve  fund  pure  and 
simple. 

(d)  Investment  fluctuation  account.  This  is  an  item  which, 
unless  further  explained,  should  never  appear  upon  the  face 


THE  LIABILITY  SIDE.  233 

of  a  balance  sheet,  and  that  for  the  simple  reason  that  its 
meaning  is  by  no  means  clear.  It  may  mean  that  investments 
have  been  re-valued  at  a  higher  figure  than  cost  price,  and 
the  proceeds  carried  to  this  account  rather  than  to  the  credit 
of  profit  and  loss  or  reserve  fund;  or,  on  the  other  hand,  it 
may  mean  that  the  investments  are  stated  in  the  balance  sheet 
at  a  higher  figure  than  their  actual  value,  and  that  the  amount 
of  the  investment  fluctuation  account  is  an  amount  set  aside 
in  anticipation  of  future  loss.  The  former  is  a  perfectly 
legitimate  form  of  special  reserve  fund;  the  proper  place  for 
the  latter  (which  is,  in  fact,  merely  a  depreciation  account) 
appears  to  be  in  reduction  of  the  stated  value  of  the  assets. 

(e)  Sinking  fund,  or  an  amount  set  aside  (and  specifically 
invested)  for  the  purpose  of  meeting  a  future  loss  upon  re- 
demption of  bonds  issued  at  a  discount,  renewal  of  leases,  &c. 

(/)  Compulsory  sinking  fund  for  the  redemption  or  ex- 
tinguishment of  bonds,  set  aside  in  accordance  with  the  pro- 
visions of  the  mortgage.  This  is  a  very  common  requirement, 
and  is  looked  upon  with  favor  by  investors  generally. 

Some  difference  of  opinion  exists  as  to  the  proper  treat- 
ment of  the  amounts  thus  raised,  and  the  opinion  of  Mr.  Dick- 
inson is  also  of  interest  in  this  connection : 

"  Sinking  funds  or  debt  extinguishment  funds  are  not  in  theory  a 
charge  against  profit  and  loss,  for  the  reason  that  they  do  not  represent 
a  loss  of  expense,  but  the  extinction  of  an  existing  liability.  Inasmuch, 
however,  as  in  most  cases  the  only  source  out  of  which  such  redemp- 
tion fund  can  be  provided  is  the  surplus  earnings,  it  is  usual  to  insert  a 
provision  in  trust  deeds  that  the  sinking  fund  is  to  be  provided  out  of 
the  profits  of  the  year.  The  discharge  of  liabilities  involves  either  a 
corresponding  reduction  in  assets  or  the  accumulation  of  other  liabili- 
ties or  surplus.  A  reduction  in  current  assets  or  the  accumulation  of 
other  liabilities  as  a  substitute  for  bonded  indebtedness  is  clearly  unde- 
sirable and  it  is  therefore  necessary  that  the  amount  applied  each  year 
to  sinking  fund  purposes  should  be  transferred  from  Profit  and  Loss 
either  to  a  special  reserve  fund  or  in  reduction  of  some  fixed  asset  ac- 
count by  way  of  provision  for  depreciation  or  otherwise.  It  must,  how- 
ever, be  remembered  that  such  provision  for  depreciation  will  be  to 


234  AUDITING. 

that  extent  represented  by  capital  instead  of  current  assets,  and  while 
there  is  no  theoretical  objection  to  this,  if  the  depreciation  fund  is 
sufficiently  large,  the  latter  necessarily  ceases  to  be  available  in  cash 
for  one  of  its  principal  purposes,  viz.,  the  renewal  of  various 
capital  assets  from  time  to  time.  If,  however,  part  of  the  fixed 
assets  are  of  a  wasting  character,  the  sinking  fund  may  be  quite 
safely  applied  in  reduction  thereof,  or  it  may  with  equal  propriety 
be  applied  in  reduction  of  goodwill  or  patents.  The  safest  way 
undoubtedly,  therefore,  in  every  case  is  to  charge  the  sinking  fund  in- 
stallment to  profit  and  loss  each  year,  and  either  credit  it  to  a  special 
sinking  fund  reserve  or  apply  it  as  depreciation  of  some  fixed  asset 
for  the  renewal  of  which  no  cash  expenditure  will  be  required  in  the 
future." 

The  above,  no  doubt,  is  sound  reasoning,  and  is  certainly- 
based  on  conservative  lines.  At  the  same  time  it  sometimes 
happens  that  some  companies  having  made  ample  provision 
for  depreciation,  &c.,  do  not  consider  it  necessary  to  treat  the 
payments  to  sinking  fund  as  a  charge  against  profit  and  loss, 
but  simply  debit  "  Sinking  Fund  "  with  the  cash  payments  to 
the  trustees.  In  these  cases  where  there  is  no  provision  in  the 
trust  deed  that  the  sinking  fund  shall  be  provided  for  out  of 
profits  there  is  no  necessity  to  charge  the  amount  thereof 
against  profit  and  loss,  and  the  charge  may  be  provided  for  by 
a  fresh  issue  of  notes  or  capital  stock. 

As  a  rule,  the  trustees  are  not  directly  accountable  to  the 
company  for  their  disposition  of  the  cash  which  they  receive, 
and  can  make  such  investments  as  they  choose,  subject  in  cer- 
tain cases  to  restrictions  requiring  them  to  first  purchase  bonds 
of  the  same  company,  provided,  of  course,  that  they  may  be 
obtainable. 

It  seldom  happens  that  these  compulsory  payments  corre- 
spond in  amount  with  proper  depreciation,  particularly  where 
the  sinking  fund  is  fixed  on  a  sliding  scale,  and  it  would  not 
seem  to  be  convenient  to  attempt  to  oflfset  one  by  the  other, 
nor,  on  the  other  hand,  for  the  reasons  urged  above,  does  it 
seem  equitable  to  compel  a  company  to  charge  off  both  depre- 
ciation and  sinking  fund  instalments. 


THE  LIABILITY  SIDE.  235 

In  view  of  the  fact  that  whenever  sinking  fund  charges  to 
profit  and  loss  are  in  addition  to  ample  charges  for  depreciation^ 
probable  losses  on  bad  debts,  &c.,  they  really  represent  undi- 
vided profits  or  surplus  which  will  revert  to  surplus  or  profit 
and  loss  account  after  the  specific  purpose  for  which  they 
have  been  temporarily  set  aside  (i.  e.,  the  redemption  of  the 
bonds  at  maturity)  has  been  fulfilled,  it  appears  that  the  cor- 
rect way  to  state  the  sinking  fund  in  the  balance  sheet  is  as  a 
separate  section  of  the  surplus  or  undivided  profits,  and  not  to 
include  it  among  the  actual  liabilities. 

{g)  The  "  reserve  "  of  a  life  assurance  company,  which  is 
a  fund  set  aside  out  of  the  surplus  premiums  paid  by  the 
assured  in  the  earlier  years  of  their  insurance  to  meet  the 
deficiency  of  such  premiums  to  cover  the  increased  risk  of 
later  years,  when  the  expectation  of  life  is  shorter  and  which 
unless  they  are  separately  stated,  must  also  provide  for  "  de- 
ferred dividends,"  which  are  in  reality  actually  allocated  to 
the  assured  each  year,  but  which  are  not  payable  until  the  expi- 
ration of  the  full  term  of  the  policy.  To  a  very  large  extent 
the  reserves  of  life  assurance  companies  are  "  premiums  paid 
in  advance,"  rather  than  "  accumulated  profits." 

There  can  be  no  doubt  but  that  it  is  improper  to  state  as  a 
reserve  fund  any  sum  which  has  not  been  actually  set  aside, 
out  of  profits,  solely  for  the  purpose  of  providing  against  un- 
foreseen contingencies. 

It  might  be  added  that  in  this  book  the  word  "  Fund  "  is. 
in  most  cases  used  in  the  same  sense  as  many  accountants  use 
the  words  "  Fund  Account"  and  where  investments  of  these 
items  are  made  they  are  stated  among  the  assets  as  "  Fund 
Investments." 

Considerable  discussion  of  this  question  has  taken  place 
recently,  it  being  contended  by  some  that  a  "  Fund  "  can  only 
be  an  asset,  the  word  itself  indicating  something  which  is 
tangible.  The  discussion,  therefore,  hinges  largely  on  the  in- 
terpretation of  the  meaning  of  the  word,  and  it  is  hoped  that 


236  AUDITING. 

there  will  very  soon  be  uniformity  of  opinion  on  the  subject. 
At  present,  however,  most  large  corporations  use  the  word  as 
mentioned  heretofore. 

THE  INVESTMENT  OF  RESERVE  FUNDS.— The 
numerous  failures  that  occurred  during  the  year  1907,  and, 
in  fact,  many  failures  of  more  recent  date,  show  that  the  mere 
existence  of  a  large  reserve  fund  does  not  in  itself  suffice  to 
ward  off  disaster,  and  hence  many  unfortunate  stockholders 
have  bitterly  stated  that  these  paper  reserves  were  "  fictitious," 
and  there  is  much  truth  in  their  contention. 

The  usual  criticism  includes  a  demand  that  reserve  funds  be 
actually  invested  in  securities  outside  the  business  itself,  and 
that  the  balance  sheet  show  them  properly  "  earmarked.'* 

It  cannot  be  too  strongly  advanced  that  the  question  as  to 
whether  or  not  any  given  reserve  fund  is  represented  by  assets 
consisting  of  marketable  securities  outside  the  business,  or  by 
less  readily  marketable  assets  employed  in  the  business  as  fixed 
(or  working)  capital,  is  comparatively  speaking  of  little  im- 
portance. The  most  casual  perusal  of  any  balance  sheet  will 
show  at  a  glance,  even  to  the  least  informed,  by  which  class  of 
assets  the  reserve  fund  is  represented.  Consequently  the  occa- 
sion does  not  arise  to  deal  specifically  with  this  point.  What 
is  of  more  importance,  and  what  cannot  be  gathered  usually 
even  by  the  most  expert  accountant  by  a  perusal  of  the  pub- 
lished accounts,  is  whether  the  so-called  reserve  fund  is  (i)  a 
bona  Ude  accumulation  of  divisible  net  profits  set  aside  (or 
reserved)  merely  to  provide  for  unforeseen  contingencies,  or  in 
general  terms  because  it  is  thought  inexpedient  to  divide  profits 
up  to  the  Hmit.  (2)  A  reserve  set  aside  out  of  profits  with  a 
view  to  retaining  in  the  possession  of  the  company  assets  that 
may  hereafter  be  applied  to  a  foreseen  and  specific  purpose — 
as,  for  example,  the  repayment  of  redeemable  bonds;  or  (3) 
a  provision,  falsely  called  reserve  fund,  set  aside  by  charging 
from  year  to  year  something  against  profits  for  the  purpose  of 
building  up  a  provision  to  meet  a  known  or  expected  deteriora- 


THE  LIABILITY  SIDE.  237 

tion  of  assets  in  the  future.  No  mere  inspection  of  a  majority 
of  published  accounts  would  enable  any  one  to  determine  to 
which  of  these  three  classes  an  item  described  as  "  reserve 
fund  "  belongs ;  hence  the  extreme  importance,  from  the  audi- 
tor's point  of  view,  of  the  adoption  of  a  correct  nomenclature. 
The  term  "  reserve  fund "  without  qualification,  ought,  it  is 
submitted,  in  all  cases  to  refer  solely  to  class  (i)  mentioned 
above.  If  the  reserve  fund  be  an  accumulation  of  divisible 
profits  "  earmarked  "  in  advance  for  a  specific  purpose,  and 
therefore  not  properly  available  for  any  other  purpose  (as  in 
the  case  of  class  (2),  the  limitations  of  that  reserve  fund  ought 
to  be  clearly  stated  upon  the  face  of  the  balance  sheet  {e.  g., 
"  Reserve  Fund  accumulated  to  provide  for  redemption  of 
bonds  in  190 — ,"  or  **  Reserve  Fund  specifically  earmarked"). 
If  a  credit  balance  that  properly  comes  under  the  definition  of 
class  (3)  is  called  "  Reserve  Fund,"  it  is  submitted  that  the 
accounts  are  to  that  extent  false  and  misleading,  and  that  the 
auditor  should  require  them  to  be  amended,  so  that  they  may 
properly  disclose  the  true  position  of  affairs.  If  his  reasonable 
requirement  in  this  respect  be  refused,  his  only  alternative 
would  appear  to  be  to  place  a  certificate  at  the  foot  of  the  bal- 
ance sheet,  to  the  effect  that  his  requirements,  as  auditor,  have 
not  been  complied  with  in  this  respect — dealing,  of  course, 
fully  with  the  subject  in  his  report  to  the  stockholders. 

The  last  paragraph  applies  specifically  to  companies  operating 
under  the  English  Companies  Acts ;  in  view  of  the  differences 
of  opinion  which  exist  in  the  United  States  as  to  the  proper 
use  of  the  words  "  Reserve  Fund  '*  it  is  considered  inadvisable 
to  advocate  such  a  course  here. 

UNDIVIDED  PROFITS.— The  last  item  upon  this  side  of 
the  balance  sheet  is  the  balance  of  undivided  profit.  It  is 
thought  preferable  to  show  this  balance  without  elaboration 
upon  the  balance  sheet,  and  in  a  "  Profit  and  Loss  Apportion- 
ment Account"  (or  the  last  section  of  the  profit  and  loss  ac- 
count) to  show  the  connection  between  the  balance  shown 
upon  the  balance  sheet  and  the  balance  of  the  profit  and  loss 


238  AUDITING. 

account  for  the  current  period.  There  is,  however,  no  objec- 
tion to  showing  the  details  upon  the  balance  sheet,  except  that 
it  does  not  appear  to  present  the  facts  of  the  case  so  clearly. 

CONTINGENT  LIABILITIES.— With  the  question  of 
contingent  liabilities  it  is  not  necessary  to  deal  at  length,  be- 
yond stating  that  all  such  liabilities  as  are  known  should  be 
noted  upon  the  balance  sheet,  even  if  it  is  anticipated  that 
they  will  not  ultimately  result  in  a  claim  against  the  company. 

GENERAL. — It  is  hardly  necessary  to  enter  in  detail  into 
the  forms  of  balance  sheets  required  for  different  classes  of 
undertakings ;  the  same  rules  apply  in  almost  all  cases,  and  al- 
though modifications  of  detail  will  appear  desirable  in  almost 
each  particular  case,  these  naturally  must  be  considered  and 
dealt  with  according  to  the  particular  circumstances  that 
obtain,  the  general  principle  in  all  cases  being  that  the  accounts 
must  not  only  be  correct,  but  also  so  clear  as  to  render  mis- 
apprehension impossible,  even  among  those  who  do  not  pro- 
fess to  be  skilled  accountants.  In  this  respect  it  is,  perhaps, 
well  to  bear  in  mind  the  particular  classes  of  persons  who  are 
likely  to  be  interested  in  the  accounts.  Thus,  in  the  case  of  a 
building  and  loan  association,  lucidity  will  be  the  great  thing 
to  be  aimed  at;  while  in  the  case  of  such  an  institution  as  a 
bank,  the  main  object  of  the  balance  sheet  is,  perhaps,  less 
to  inform  stockholders  as  to  the  amount  of  their  profits  than  to 
allow  the  public  to  form  a  reliable  estimate  upon  the  bank's 
stability.  It  may  be  added  that  an  "  account  "  is  not  primarily 
a  collection  of  figures;  it  is  a  narration  of  events  and  facts; 
while  a  person  appointed  to  hear  and  approve  such  narration 
is  called  an  "  auditor."  The  importance  of  these  points  lies 
in  the  circumstance  that,  although  accounts  are  now  written 
(or  printed)  instead  of  being  delivered  orally,  the  narration 
(or  wording)  is  at  least  as  material  as  the  figures  themselves. 

The  English  Companies  Act  heretofore  referred  to  indicates 
the  accounts  to  which  stockholders  are  entitled  more  clearly 
than  is  the  case  with  most  of  our  corporation  laws. 


CONSOLIDATED  BALANCE  SHEETS.  239 

The  following  is  an  extract  from  Table  A  of  the  act  of  1908: 

Section  106.  Once  at  least  in  every  year  the  directors  shall  lay  be- 
fore the  company  in  general  meeting  a  profit  and  loss  account  for 
the  period  since  the  preceding  account  or  (in  the  case  of  the  first  ac- 
count) since  the  incorporation  of  the  company,  made  up  to  a  date  not 
more  than  six  months  before  such  meeting. 

Section  107.  A  balance  sheet  shall  be  made  out  in  every  year  and 
laid  before  the  company  in  general  meeting,  made  up  to  a  date  not 
more  than  six  months  before  such  meeting.  The  balance  sheet  shall 
be  accompanied  by  a  report  of  the  directors  as  to  the  state  of  the 
company's  affairs,  and  the  amount  which  they  recommend  to  be  paid 
by  way  of  dividend,  and  the  amount,  if  any,  which  they  propose  to 
carry  to  a  reserve  fund. 

Section  108.  A  copy  of  the  balance  sheet  and  report  shall,  seven 
days  previously  to  the  meeting,  be  sent  to  the  persons  entitled  to  receive 
notices  of  general  meetings  in  the  manner  in  which  notices  are  to  be 
given  hereunder. 

Audit. 

Section  109.  Auditors  shall  be  appointed  and  their  duties  regulated 
in  accordance  with  sections  one  hundred  and  twelve  and  one  hundred 
and  thirteen  of  the  Companies  (Consolidation)  Act,  1908,  or  any 
statutory  modification  thereof  for  the  time  being  in  force. 

CONSOLIDATED    BALANCE    SHEETS   AND    PROFIT 
AND  LOSS  STATEMENTS. 

The  proper  method  of  stating  the  accounts  of  corporations, 
which  are  generally  know^n  as  "  holding  "  companies,  has  re- 
ceived considerable  attention  recently  because  it  is  believed 
that  the  omission  on  the  part  of  some  corporations  to  take  up 
the  losses  of  subsidiary  companies,  when  they  have  included 
among  their  own  earnings  all  the  profits,  has  resulted  in 
erroneous  opinions  as  to  the  actual  net  earnings  of  the  corpora- 
tions in  question. 

Frequently,  the  balance  sheet  of  the  holding  company 
simply  gives  its  own  assets  and  liabilities,  and  these  convey 
practically  no  information  at  all  so  far  as  the  actual  condi- 


240  AUDITING. 

tion  of  the  subsidiary  companies  is  concerned.  Ift  many  in- 
stances very  large  loans  to  underlying  companies  are  included 
in  the  assets.  In  the  absence  of  specific  information  as  to  the 
separate  earnings  or  condition  of  such  undertaking,  it  is 
impossible  to  judge  whether  such  an  advance  is  or  is  not  a 
good  asset.  It  becomes,  therefore,  a  grave  matter  of  principle 
for  the  auditor  to  decide,  and  the  form  of  the  accounts  in  this 
instance  becomes  of  unusual  importance. 

The  opinion  of  A.  Lowes  Dickinson,  F.C.A.,  C.P.A.,  on 
this  subject,  as  reflected  in  his  paper  read  at  the  St.  Louis  Con- 
gress of  accountants,  is  of  importance,  as  it  is  believed  that  the 
views  there  expressed  represent  the  best  accountancy  prac- 
tice : — 

"  During  the  last  few  years  the  correct  statement  of  the  earnings  of 
a  company  controlling  a  number  of  subsidiary  companies  has  required 
much  consideration.  Legally,  the  earnings  of  such  a  corporation  con- 
sists of  the  results  of  its  own  operations,  together  with  any  dividends 
which  may  be  declared  on  the  stocks  which  it  owns  in  the  subsidiary 
companies;  and  so  long  as  these  stocks  represent  only  minority  inter- 
ests in  companies  which  are  not  in  any  way  controlled  or  operated  by 
the  directors  of  the  holding  company,  it  would  seem  that  a  profit  and 
loss  account  prepared  in  such  a  way  would  be  a  correct  and  proper 
statement  from  an  accounting  as  well  as  from  a  legal  point  of  view. 
During  recent  years,  however,  the  practice  of  consolidating  a  number 
of  concerns  by  a  control  of  stock  rather  than  by  an  absolute  purchase 
of  the  business  has  grown  into  favor,  and  consequently  it  is  usual 
to  find  the  holding  company  owning  either  the  whole  or  a  large 
majority  of  the  stocks  of  a  number  of  companies  doing  a  similar 
business,  appointing  the  directors  of  these  sub-companies,  dictating 
their  policy  and  generally  acting  in  every  way  as  if  it  absolutely 
owned  the  whole  property.  Under  such  conditions  it  is  submitted  that 
no  statement  of  earnings  can  be  considered  correct  which  does  not 
show  in  one  account  the  profits  or  losses  of  the  whole  group  of  com- 
panies, irrespective  of  whether  dividends  have  or  have  not  been 
declared  thereby.  If  this  principle  be  not  insisted  upon,  it  is  within 
the  power  of  the  directors  of  the  holding  company  to  regulate  its  profits 
according,  not  to  facts,  but  to  their  own  wishes,  by  distributing  or 
withholding  dividends  of  the  subsidiary  companies;  or  even  to 
largely  overstate  the  profits  of  the  whole  group  by  declaring 
large  dividends  in  those  sub-companies  which  have  made  profits, 
while  entirely  omitting  to  make  provision  for  losses  which  have  been 


CONSOLIDATED    BALANCE    SHEETS.  24I 

made  by  other  companies  in  the  group.  It  is  doubtful  whether  there 
is  any  existing  law  which  could  legally  require  a  corporation  to  make 
up  its  statement  of  profits  on  the  basis  here  suggested,  but  possibly 
it  may  eventually  be  found  that  the  ordinary  rule  referred  to  at  the 
commencement  of  this  paper,  of  a  reasonable  valuation  of  assets,  may 
be  made  to  cover  this  point  for  the  following  reasons: 

"  It  is  clear  that  whatever  the  value  of  an  investment  in  a  corpora- 
tion may  be  at  a  particular  date,  its  value  at  any  subsequent  date 
(other  things  being  equal)  must  be  greater  or  less  by  the  amount  of 
the  profits  or  losses  made  during  the  intervening  period.  Even  if  other 
conditions  at  the  two  dates  are  not  the  same,  and,  quite  apart  from 
any  consideration  of  the  earnings  or  losses  during  the  intervening 
period,  there  is  a  considerable  appreciation  or  depreciation  in  the 
investment,  that  appreciation  or  depreciation  must  undoubtedly  be 
more  or  less,  respectively,  by  reason  of  profits  earned  or  losses  in- 
curred. In  this  case  the  change  in  value  of  the  asset  is  at  any  rate 
partly  due  to  the  result  of  the  operations  for  the  purpose  of  which  the 
investment  is  held.  On  the  general  principle,  therefore,  that  a  profit 
and  loss  account  should  take  into  account  all  profits  or  losses  resulting 
from  the  trading  operations,  but  should  not  take  into  account  the 
profits  or  losses  arising  from  a  revaluation  of  capital  assets,  it  may 
eventually  be  held,  on  legal  as  well  as  on  accounting  principles,  that 
the  statement  of  earnings  presented  by  a  holding  company  is  not 
correct  unless  it  takes  into  account  by  way  of  either  a  reserve  or  a 
direct  addition  to  or  deduction  from  the  capital  value  of  the  invest- 
ment the  profits  or  losses  made  in  operating  the  subsidiary  com- 
panies. 

"  One  other  difHcult  point  is  the  determination  of  what  is  or  is  not 
a  constituent  company  whose  profits  and  losses  should  be  brought 
into  account  in  this  manner.  It  is  suggested  that  this  depends  partly 
on  the  proportion  of  stock  owned  and  partly  upon  the  degree  of  con- 
trol exercised  by  the  holding  company.  When  the  latter  owns  at  least 
a  majority  of  the  stock,  operates  the  company,  dictates  its  policy  and 
practically  treats  its  property  as  its  own,  subject  only  to  the  right 
of  the  minority  stockholders  to  receive  a  share  of  the  profits,  the 
conditions  would  appear  to  be  such  as  to  require  the  proportion  of 
profits  and  losses  corresponding  to  the  stock  owned  to  be  taken  up; 
while,  on  the  other  hand,  a  mere  majority  ownership  of  stock  without 
any  effective  control  of  the  management  and  operation  might  properly 
be  treated  as  an  investment,  only  subject  to  the  same  rules  as  other 
investments  of  a  similar  character." 

Very  little  need  be  added  to  the  above  except  that  the  last 
clause  may  possibly  be  misunderstood.    It  is  quite  correct  that 


242  AUDITING. 

its  proportion  of  profits,  only,  should  be  taken  up,  but  in  many 
cases  a  holding  company  owning,  say,  ninety  per  cent,  of  the 
stock  of  another  company,  which  is  being  operated  by  it  in 
connection  with  other  companies,  should  take  up  all  the  loss  of 
the  latter  rather  than  its  proportion  only,  which  in  this  case 
would  be  ninety  per  cent.  The  reason  for  this  is  obvious.  If 
the  subsidiary  company  is  an  important  or  necessary  link  in 
the  group  usually  operated  by  holding  companies,  and  is  losing 
money  in  its  operations,  it  almost  invariably  happens  that  the 
parent  company  will  be  compelled  to  make  cash  advances  suffi- 
cient to  cover  the  losses  sustained.  These  advances  will  be 
carried  as  assets  by  the  holding  company,  and  should  be  scru- 
tinized as  carefully  as  other  accounts  receivable.  Obviously, 
advances,  especially  those  without  security,  to  a  company  whose 
finances  are  unsatisfactory  or  whose  operations  have  been  uni- 
formly unprofitable,  cannot  be  looked  upon  as  good  unless  a 
critical  examination  proves  this  to  be  a  fact. 

If  the  suggestion  that  the  entire  loss  be  taken  up  in  the  man- 
ner advocated  above  is  not  acceptable  to  the  directors,  it 
might  be  stated  in  another  way,  viz.,  treat  the  ninety  per  cent, 
and  the  ten  per  cent,  as  separate  items,  covering  the  latter  by 
charging  profit  and  loss  and  crediting  a  reserve  account  in 
the  same  way  that  other  bad  or  doubtful  debts  are  treated. 

Where  the  earnings  of  subsidiary  companies  have  been  car- 
ried into  the  books  of  the  holding  company,  it  follows,  of 
course,  that  either  some  asset  account,  such  as  that  represent- 
ing the  investment  in  the  subsidiary  company,  has  been  corre- 
spondingly increased,  or  else  it  will  be  debited  to  an  account 
called  "  Profits  of  Subsidiary  Companies,"  and  the  holding 
company's  current  profit  and  loss  account  credited.  Fol- 
lowing out  the  same  line  where  a  loss  has  been  made,  the  In- 
vestment Account  (or  any  other  account  which  represents  the 
cost  of  the  underlying  property),  or  the  account  "Profits  of 
Subsidiary  Companies,"  should  be  correspondingly  decreased 
and  the  current  profit  and  loss  account  of  the  holding  com- 
pany debited. 


CONSOLIDATED    BALANCE    SHEETS.  243 

The  rule  that  the  whole  loss  on  operations  of  an  underlying 
company  must  be  taken  up  by  the  holding  company  cannot 
apply  where  the  operations  of  the  subsidiary  company  result 
in  a  profit.  The  only  legitimate  way  by  which  the  holding 
company  can  secure  its  proportion  of  this  profit  being  through 
dividends,  it  follows,  of  course,  that  the  minority  interests, 
no  matter  how  small,  will  receive  their  share,  although  thtv 
can  never  be  depended  upon  to  contribute  any  proportion 
whatever  of  the  losses. 

Where  it  has  not  been  the  practice  to  carry  the  results  of 
the  operations  of  subsidiary  companies  into  the  books  of  the 
holding  company,  but  where  a  consolidated  balance  sheet  and 
earnings  statement  is  to  be  prepared,  the  latter  should,  for 
the  reasons  set  forth,  take  up  the  entire  losses  of  all  companies 
where  the  interest  is  overwhelming.  If  this  is  done,  there  can 
be  no  objection  to  carrying  the  advances  to  such  companies 
as  good,  but  if  the  advances  are  greater  than  the  aggregate 
losses  taken  up,  great  care  must  be  taken  to  ascertain  that 
the  losses  shown  by  the  books  of  the  subsidiary  company  are 
accurately  determined. 

Of  course,  this  is  a  matter  which  naturally  varies  with  the 
facts  in  each  particular  case.  In  the  event  of  the  loss  being 
an  extraordinary  one,  likely  to  be  recouped  in  subsequent 
years,  the  question  takes  another  aspect,  as  is  also  the  case 
where  the  minority  interest  is  considerable,  and  where  the 
whole  burden  of  advances,  &c.,  does^not  fall  upon  the  holding 
company. 

It  might  be  urged  that  if  the  unprofitable  company  is  not 
a  necessary  part  of  the  general  undertaking,  its  operations 
could  be  suspended  and  further  losses  avoided;  in  such  an 
event,  if  the  losses  on  operations  have,  as  a  matter  of  fact, 
been  taken  care  of  by  the  holding  company  through  its  ad- 
vances, the  entire  amount  of  such  loss  will  still  have  to  be 
taken  up,  because  it  cannot  be  assumed  in  such  a  case,  any 
more  than  in  a  going  concern,  that  the  minority  interests  will 
contribute  their  share  of  the  losses.    This  principle,  however, 


244  AUDITING. 

does  not  cover  any  capital  loss  which  may  ensue,  and  it  will 
have  to  be  dealt  with  on  its  merits. 

A  full  discussion  of  the  accounts  of  holding  companies  will 
be  found  in  the  paper,  "The  Accounting  of  Industrial  Enter- 
prises," by  William  M.  Lybrand,  C.P.A.,  reprinted  in  the  1908 
year  book  of  the  American  Association  of  Public  Account- 
ants, and  which  can  be  secured  from  the  Accountancy  Publish- 
ing Co. 


CONCLUSION. 

In  considering  these  matters,  however,  it  must  be  borne 
in  mind  that  it  is  very  exceptional  for  the  form  in  which 
accounts  are  stated  for  the  stockholders  to  be  actually 
under  the  control  of  the  auditor.  As  a  rule,  by-laws  provide 
that  the  accounts  shall  be  rendered  in  such  form  as  the 
directors  shall  think  fit,  and  in  such  cases  it  is,  of  course,  im- 
possible for  the  auditor  to  dictate  as  to  the  precise  form  to 
be  adopted.  This,  however,  does  not  release  him  from  the  re- 
sponsibility of  judging  as  to  the  fitness  of  the  form  in  which 
the  accounts  are  rendered  by  the  directors.  In  this  respect  he 
is  placed  in  a  position  and  furnished  with  information  which 
is  withheld  from  the  general  body  of  the  stockholders,  for  the 
express  purpose  of  satisfying  himself  that  the  accounts  submit- 
ted by  the  directors  to  the  stockholders  are  such  as  will  reason- 
ably disclose  the  position  of  the  company.  Considerations  with 
regard  to  the  form  which  the  accounts  should  take  are  fre- 
quently of  a  nature  which  the  auditor  must  of  necessity  weigh 
for  himself ;  for,  inasmuch  as  the  stockholders  have  no  knowl- 
edge of  the  transactions  or  position  of  the  company  other  than 
that  which  they  gain  from  a  perusal  of  the  directors'  accounts 
and  the  auditor's  report,  it  stands  to  reason  that  if  the  accounts 
do  not  sufficiently  disclose  these  things,  it:  may  frequently  hap- 
pen that  the  stockholders  themselves  would  have  no  reason  to 
suspect  that  the  accounts  were  not  all  that  they  should  be.  It 
therefore  follows  that,  although  the  auditor  do€S  not  have  the 
drafting  of  a  company's  accounts,  it  is  necessary  for  him  in  all 


CONCLUSION.  245 

cases  to  consider  the  form  in  which  they  are  submitted  for  his 
approval,  and  not  merely  to  content  himself  with  an  examina- 
tion of  their  technical  correctness.  It  has  been  stated  by  some 
that,  the  accounts  submitted  to  the  stockholders  being  the 
accounts  of  the  directors,  they,  and  they  only,  are  responsible 
to  the  stockholders  for  the  form.  This  is  true  to  the  extent 
that  the  auditor  has  no  power  to  compel  the  directors  to 
modify  the  form  of  their  accounts;  but  it  is  not  true  in  the 
sense  that  if  the  accounts  submitted  are,  so  far  as  they  go, 
correct,  the  auditor  is  under  no  responsibility  to  specially 
report  in  such  cases,  as  they  are  insufficient  to  enable  any  one 
examining  them  to  obtain  a  correct  idea  of  the  company's 
position.  Were  this  the  case,  it  would  indeed  be  difficult  to 
see  in  what  respect  the  stockholders  gained  by  an  audit  of 
their  accounts,  for  it  is  obvious  that  it  would  be  possible  to 
conceal  almost  anything  in  the  shape  of  fraud  or  unjustifiable 
extravagance.  The  stockholders  have,  however,  a  clear  right 
to  such  accounts  as  will  enable  them  from  time  to  time  to  judge 
of  the  value  of  their  investment ;  and  it  is  for  the  purpose  of 
making  the  accounts  reliable  for  this  purpose  that  an  auditor  is 
appointed.  And  while  there  rests  with  him  the  serious  respon- 
sibility of  concealing  such  matters  of  internal  detail  as  would, 
if  divulged,  tend  to  damage  the  position  of  the  business,  yet, 
on  the  other  hand,  he  must  not  fail  to  remember  that  it  is 
the  stockholders,  and  not  the  directors,  who  are  the  masters 
of  the  fortune  of  the  company,  and  that  (excepting  matters  of 
internal  detail)  they  have  an  undisputable  right  to  the  fullest 
and  clearest  information. 

There  has  been  a  decided  advance  recently  along  the  line 
of  improved  forms.  It  may  be  due  to  a  demand  on  the  part  of 
stockholders,  but  in  any  event  it  is  encouraging  to  those  who 
have  striven  towards  it  for  years.  Appendix  D  to  this  book 
contains  the  more  important  standard  forms  now  in  use. 


CHAPTER  VIII. 


WHAT  ARE  PROFITS? 


In  the  preceding  chapters  most  of  the  points  arising  in  the 
course  of  an  audit,  with  a  view  to  ascertaining  that  all  due 
precautions  have  been  taken  to  test  the  accuracy  of  accounts 
before  certifying  them,  have  been  considered  in  some  detail; 
but  it  is  advisable  to  review  some  of  these  various  questions 
from  the  point  of  view  of  considering  whether  or  not  the 
amount  of  profit  stated  upon  the  face  of  the  accounts  is  actually 
available  for  dividend.  It  is  most  important  to  remember  in 
this  connection,  however,  that  until  an  undertaking  has  been 
actually  wuund  up,  any  statement  as  to  the  profits  earned  is  to 
a  great  extent  merely  an  estimate,  or  an  expression  of  opinion, 
and  not  a  stalement  of  facts. 

ADVANTAGES  OF  DOUBLE  ENTRY. 

The  reader  will  hardly  require  to  be  reminded  that,  in  the 
case  of  an  ordinary  corporate  undertaking,  the  amount  of 
profit  available  for  distribution  will  be  represented  on  the 
balance  sheet  by  the  excess  of  the  assets  there  disclosed  over 
the  liabilities  and  paid-up  capital  of  the  undertaking.  But  it  is 
desirable  for  the  auditor,  in  order  to  make  sure  of  his  position, 
to  look  at  the  patter  not  merely  from  a  balance  sheet  point  of 
view,  but,  in  the  first  place,  to  carefuHy  scrutinize  the  revenue 
account  in  order  to  see  that  no  sources  of  income  have  been 
taken  credit  for  unduly,  and  that  all  reasonable  expenses  have 
been  properly  debited,  and  then  to  compare  the  profit  shown 
by  such  revenue  account  with  the  surplus  before  mentioned, 
stated  to  be  available  on  the  face  of  the  balance  sheet,  after 

246 


CAPITAL  V.  REVENUE.  247 

scrutinizing  all  the  assets  and  liabilities  there  disclosed.  By 
this  means  he  will  have  the  advantage  of  looking  at  the  matter 
from  two  points  of  view,  which,  in  so  difficult  a  question  as  the 
assessment  of  actual  profits,  is  of  the  utmost  value. 

CAPITAL  V.  REVENUE. 

It  will  be  seen  from  what  has  been  said  above  that,  at  all 
events  economically  speaking,  no  profits  are  available  for  dis- 
tribution until  provision  has  been  made  for  keeping  the  whole 
of  the  paid-up  capital  of  the  undertaking  intact.  The  ab- 
solute legal  necessity  for  this  provision  has,  however,  been 
rendered  somewhat  doubtful  by  many  decisions  which  have 
been  given  in  the  courts  from  time  to  time.  The  English  de- 
cisions are,  of  course,  more  numerous  than  those  which  can 
be  found  reported  in  the  United  States,  but  in  view  of  the 
fact  that  each  case  necessarily  is  decided  on  its  merits,  it  is 
scarcely  worth  while  to  review  all  of  them  in  this  volume. 
The  student,  who  may  be  specially  interested  in  this  branch 
of  accountancy,  however,  finds  much  of  interest  in  the  very 
full  law  reports  which  are  reviewed  in  Dicksee's  "Auditing," 
Seventh  English  Edition. 

It  may  be  stated  in  this  connection,  however  (although 
necessarily  briefly  and  incompletely),  that  the  effect  of  all  these 
English  decisions  was  that  under  certain  circumstances  it 
might  not  be  necessary  for  a  company,  before  declaring  a 
dividend  out  if  profits  alleged  to  have  been  earned,  to  provide 
in  that  year's  accounts  for  the  whole  of  the  loss  caused  by 
the  shrinkage  in  intrinsic  value  of  the  whole  or  a  portion 
of  its  assets.  In  one  case*  it  is  true  that  the  actual  facts  dis- 
closed did  not  place  it  beyond  doubt  that  the  fixed  assets  of 
the  company  were  in  fact  less  valuable  than  when  they  were 
taken  over  in  the  first  instance;  but  in  other  cases  the  fact 
that  some  depreciation  had  occurred  was  undisputed,  and  al- 
though some  provision  had  been  made  for  this  depreciation 


*Leev.  The  Neuchatel  Asphalte  Company,  Limited  (1889)   (Dicksee's  Auditing, 
Seventh  English  Edition,  page  610). 


248  AUDITING. 

in  two  reported  cases,*  it  was  not  seriously  contended  that 
a  sufficient  sum  had  been  written  off  to  cover  the  whole  of  the 
loss. 

On  the  other  hand,  it  is  very  desirable  that  no  undue  im- 
portance should  be  attached  to  these  decisions,  for  it  must 
be  remembered  that  several  of  the  cases  arose  out  of  a  motion 
upon  the  part  of  one  or  more  stockholders  to  obtain  an  in- 
junction against  the  directors  of  a  company,  restraining  them 
from  declaring  a  dividend;  and  that,  in  the  absence  of  any 
evidence  that  creditors  would  be  defrauded,  or  the  rights  of 
one  or  more  classes  of  stockholders  seriously  prejudiced,  the 
courts  would  naturally  not  lightly  interfere  with  the  deliberate 
action  of  the  directors,  endorsed  by  a  resolution  of  the  com- 
pany passed  in  general  meeting,  in  regard  to  a  matter  which 
would  certainly  appear  to  be  essentially  one  of  internal  admin- 
istration. 

The  most  difficult  questions  that  arise  under  this  heading 
proper  occur  in  the  case  of  a  company  which  has  sold  a  part 
of  its  undertaking,  but  the  general  principles  to  be  applied  in 
such  cases  have  been  fairly  well  defined  by  the  courts.  In  one 
English  case,t  it  was  decided  that  so  long  as  it  was  not  ultra 
vires  the  company,  a  profit  made  on  the  sale  of  part  of  the 
undertaking  was  available  for  dividend — upon  the  principle, 
apparently,  that  there  was  nothing  in  the  English  Companies 
Acts  themselves  to  prevent  a  company  declaring  that  one  of  the 
"  objects  "  for  which  it  was  incorporated  was  to  from  time  to 
time,  as  opportunity  offered,  sell  at  a  profit  undertakings 
which  had  in  the  first  instance  been  acquired  not  for  the  pur- 
pose of  re-sale,  but  with  the  idea  of  working  them  for  revenue 
purposes.  That  is  to  say,  tbere  is  no  statutory  provision  to 
prevent  a  company  from  changing  its  mind,  and  deliberately 
converting  fixed  assets  into  floating  assets.     To  some  extent, 


*  Wilmer  v.  McNamara  &  Company,  Limited  (1895)  (Dicksee's  Auditing,  Seventh 
English  Edition,  page  628,  and  Dovey  v.  Corey  (1901)  (Dicksee's  Auditing,  Seventli 
English  Edition,  page  767). 

t  Lubbock  V.  British  Bank  of  South  America,  Limited  (1892)  (Dicksee's  Auditing, 
Seventh  English  Edition,  page  618). 


CAPITAL  V.  REVENUE.  249 

however — although  to  no  unreasionable  extenii — ^this  some- 
what general  decision  was  limited  by  another  case  decided 
some  years  later.*  Briefly  stated,  the  position  here  was  that 
the  company  had  in  the  first  instance  acquired  a  number  of  mis- 
cellaneous assets  for  a  lump  sum,  and  had — doubtless  in  the 
exercise  of  a  bona  fide  discretion  vested  in  the  directors — 
apportioned  the  purchase  price  over  the  various  assets  so 
acquired.  One  of  these  assets  seems  to  have  been  a  book 
debt  of  an  extremely  doubtful  nature,  which  was  valued  at 
nil,  but  which  eventually  produced  to  the  company  the  sum 
of  $130,000.  The  directors  sought  to  regard  the  whole  of  this 
sum  as  profit,  doubtless  on  the  footing  that  the  asset  in  ques- 
tion had  cost  the  company  nothing,  and  that,  therefore,  what- 
ever it  actually  realized  was  clear  profit.  On  a  motion  on 
behalf  of  debenture-holders  and  a  stockholder  to  restrain  the 
application  of  these  moneys  to  the  payment  of  a  dividend,  the 
judge  made  an  order  in  the  terms  applied  for.  In  doing  so, 
however,  he  said  "  It  is  clear,  I  think,  that  an  appreciation  in 
the  total  value  of  capital  assets,  if  duly  realized  by  sale  or  get- 
ing  in  of  some  portion  of  such  assets,  may  be  a  proper  case  to 
be  treated  as  available  for  purposes  of  dividend  ; "  but  he  held 
— and  accountants  will  doubtless  agree  with  his  holding — ^that 
so  material  a  disproportion  between  the  directors'  original 
apportionment  of  the  purchase-price  among  the  assets  acquired 
and  the  realizable  value  of  one  of  those  assets  clearly  suggested 
that,  before  any  such  alleged  profit  as  that  referred  to  can  be 
safely  treated  as  true  profit,  the  whole  business  of  the  appor- 
tionment of  the  purchase-price  ought  to  be  gone  over  afresh. 
Had  the  directors  been  prepared  to  re-value  all  their  fixed 
assets,  and  after  such  re-valuation  to  only  treat  as  profit  the 
excess  of  the  bona  fide  value  of  the  fixed  assets  retained  plus 
the  proceeds  of  assets  realized,  over  the  original  cost  of  all 
assets  as  profit,  there  can,  it  is  thought,  be  but  little  doubt  that 
the  judge  would  have  sanctioned  a  di\'idend  paid  out  of  profits 
so  computed. 


*  Foster  v.  The  New  Trinidad  Lake  Asphalte  Company,  Limited  (1900)  (Dicksee's 
Auditing,  Seventh  English  Edition,  page  754) 


250  AUDITING. 

It  is  hardly  likely,  however,  that  many  of  the  English  de- 
cisions will  be  followed  in  this  country,  because  our  corpora- 
tion laws  are  not  only  radically  different  from  theirs,  but 
usually  some  provision  will  be  found  in  most  of  our  statutes 
which  bears  directly  on  the  subject.  It  is  true,  however,  that 
most  of  the  English  decisions  as  to  what  are,  or  what  are  not, 
profits  are  based  on  the  rules  of  the  common  law  of  England, 
and  in  the  majority  of  our  States  the  same  rules  or  usages  are 
followed. 

The  most  notable  American  decisions  along  this  line  are 
those  against  the  directors  of  the  American  Malting  Co., 
rendered  during  the  years  of  1903  and  1904,  which  not  only  at- 
tracted attention  from  the  fact  that  the  directors  were  com- 
pelled to  pay  back  to  the  company  something  in  excess  of  one 
million  dollars  but  they  were  also  of  interest  on  account  of 
the  accountancy  principles  involved. 

One  of  the  cases  arose  in  the  New  Jersey  courts,  and  one  in 
New  York.  The  latter  is  fully  reported  in  Appendix  "  C." 
The  following  brief  resume  of  the  principal  points  in  the  New 
Jersey  decision  appears  properly  at  this  point. 

APPLETON  V.  AMERICAN  MALTING  CO.  65  New 
Jersey  Equity,  page  375.  Court  of  Errors  and  Appeals  New 
Jersey.  March  11,  1903.  Section  30  of  the  Corporation  Act 
of  New  Jersey  provides  as  follows : 

"  No  corporation  shall  make  dividends,  except  from  the  surplus  or 
net  profits  arising  from  its  business,  nor  divide,  withdraw,  or  in  any 
way  pay  to  the  stockholders,  or  any  of  them,  any  part  of  its  capital 
stock,  or  reduce  its  capital  stock,  except  according  to  this  act,  and  in 
case  of  any  violation  of  the  provisions  of  this  section,  the  directors 
under  whose  administration  the  same  may  happen  shall  be  jointly 
and  severally  liable,  at  any  time  within  six  years  after  paying  such 
dividend,  to  the  corporation  and  its  creditors,  in  the  event  of  its 
dissolution  or  insolvency,  to  the  full  amount  of  the  dividend  made 
or  capital  stock  so  divided,  withdrawn,  paid  out  or  reduced,  with  in- 
terest on  the  same  from  the  time  such  liability  accrued :  provided,  that 
any  director  who  may  have  been  absent  when  the  same  was  done,  or 
who  may  have  dissented  from  the  act  or  resolution  by  which  the  same 


CAPITAL  V.  REVENUE.  2$  I 

was  done,  may  exonerate  himself  from  such  liability  by  causing  his 
dissent  to  be  entered  at  large  on  the  minutes  of  the  directors,  at  the 
time  the  same  was  done,  or  forthwith  after  he  shall  have  notice  of  the 
same,  and  by  causing  a  true  copy  of  said  dissent  to  be  published,  within 
two  weeks  after  the  same  shall  have  been  so  entered,  in  a  newspaper 
published  in  the  county  where  the  corporation  has  its  principal  office." 

Certain  directors  of  the  American  Malting  Company 
voted  for  dividends  which  were  paid  out  of  capital  in  violation 
of  the  above  statute. 

Thereupon  certain  stockholders  filed  a  bill  in  equity  to  com- 
pel the  directors  of  the  company  to  pay  back  said  dividends 
into  the  treasury  of  the  company. 

The  directors  contended  that  they  were  liable  only  in  case 
of  the  dissolution  or  insolvency  of  the  company,  and  that  as 
their  conduct  had  not  resulted  in  either  the  dissolution  or  the 
insolvency  of  the  company,  they  were  not  liable. 

The  court,  however,  held  them  liable,  delivering  the  follow- 
ing opinion: 

"It  is  argued  by  the  demurrants  (directors),  as  has  been  already 
stated,  that  the  statute,  so  construed,  is  grossly  unjust  and  inequitable, 
in  that  it  requires  the  directors  to  pay  into  the  treasury  of  the  corpora- 
tion, for  the  benefit  of  the  stockholders,  the  amount  of  the  deficit, 
although  the  stockholders,  not  the  directors,  have  in  their  pockets  the 
portion  of  the  capital  which  has  been  withdrawn.  The  argument 
assumes  that  there  will  be  no  transfer  of  the  stock  of  the  company 
during  the  period  of  the  liability  of  the  directors.  The  assumption  is 
unwarranted.  The  very  declaration  of  the  dividend,  evidencing,  as  it 
does,  the  apparent  prosperity  of  the  company,  creates  a  desire  on  the 
part  of  outsiders  to  become  holders  of  the  stock.  It,  at  the  same 
time,  decreases  the  actual,  while  increasing  the  apparent,  value  of  the 
stock.  The  result  is  to  afford  unscrupulous  directors,  and  stockholders 
who  are  cognizant  of  the  illegal  action  of  the  board,  an  opportunity  to 
unload  their  holdings  upon  innocent  purchasers  at  fraudulently  inflated 
prices.  It  is  eminently  just  that  the  persons,  whose  wrongful  act  has 
caused  loss  to  those  who  have  been  induced  by  it  to  become  stock- 
holders, should  make  good  that  loss,  but  is  it  inequitable  that  stock- 
holders who  have  innocently  participated  in  the  distribution  of  the 
illegal  dividends  should  have  their  stock  restored  to  its  normal  value  by 
contribution  from  the  directors  who  have  impaired  the  capital,  without 


1 


252  AUDITING. 

being  first  required  to  pay  back  the  dividend  so  paid  to  them?  The 
ordinary  purchaser  of  corporate  stock  holds  it  as  an  investment.  He 
rightly  considers  and  treats  the  dividends  paid  upon  it  as  income. 
In  many  instances  the  income  is  required  to  meet  the  expenses  of 
living,  and  is  entirely  expended  for  that  purpose.  To  say  that  a 
person  who  has  been  unwittingly  induced  to  exhaust  his  principal,  by 
the  mistaken  or  fraudulent  representation  of  those  to  whom  he  has 
entrusted  it  that  what  has  been  paid  to  him  as  income,  suffers  no 
injury,  is  absurd.  To  refuse  him  redress,  except  upon  condition  that 
he  return  the  moneys  which  he  has  expended  in  the  belief  that  his 
capital  was  intact — notwithstanding  that  by  such  expenditure  he  is 
rendered  penniless  is  to  put  a  premium  upon  fraud  in  corporate  man- 
agement." 

From  the  auditor's  standpoint  the  New  York  decision  is  of 
far  greater  importance,  and  the  entire  text  is  well  worth  read- 
ing. 

It  should  be  noted  that  the  New  Jersey  law  (already  quoted) 
requiring  dividends  to  be  paid  only  from  profits,  is  similar  to 
the  New  York  statute.  Section  23  of  the  (New  York)  Stock 
Corporation  Law  provides  : 

"The  directors  of  a  stock  corporation  shall  not  make  dividends, 
except  from  the  surplus  profits  arising  from  the  business  of  such  cor- 
poration; nor  divide,  withdraw  or  in  any  way  pay  to  the  stockholders, 
or  any  of  them,  any  part  of  the  capital  of  such  corporation,  or  reduce 
its  capital  stock,  except  as  authorized  by  law.  In  case  of  any  violation 
of  the  provisions  of  this  section,  the  directors  under  whose  adminis- 
tration the  same  may  have  happened,  except  those  who  may  have 
caused  their  dissent  therefrom  to  be  entered  at  large  upon  the  minutes 
of  such  directors  at  the  time,  or  were  not  present  when  the  same 
happened,  shall  jointly  and  severally  be  liable  to  such  corporation  and 
to  the  creditors  thereof  to  the  full  amount  of  the  capital  of  such  cor- 
poration so  divided,  withdrawn,  paid  out  or  reduced." 

The  court  in  passing  on  the  question  of  "  What  are  Net 
Profits?"  quotes  the  following  definition  from  the  Century 
Dictionary:  "What  remains  as  the  clear  gain  of  any  business 
after  deducting  the  capital  invested  in  the  business,  the  ex- 
penses incurred  in  its  management  and  the  losses  sustained  by 
its  operation." 


CAPITAL  V.  REVENUE.  253 

It  will  be  noted  that  the  main  controversy  in  the  case  arose 
over  the  question  as  to  whether  the  company  had  a  right  to 
declare  dividends  from  book  profits  which  were  largely,  if 
not  wholly,  anticipated.  Referring  to  this  point  the  court  said : 

"  To  calculate  months  in  advance  on  the  result  of  the  future  transac- 
tions, and  on  such  calculations  to  declare  dividends,  was  to  base  such 
dividends  on  paper  profits — hoped  for  profits,  future  profits — and  not 
upon  the  surplus  or  net  profits  required  by  law.  It  does  not  seem  to 
me  that  you  can  *  divide,'  that  is,  make  a  dividend  of  a  hope  based  on 
an  expectation  of  a  future  delivery  at  a  favorable  price  of  what  is  not 
yet  in  existence,  under  the  statute,"  and  further  on :  "  It  does  not 
seem  to  me  that  in  these  days  of  great  corporations  and  of  combina- 
tions into  one  of  many  corporations  it  is  asking  too  much  of  direc- 
tors, fiduciary  officers  as  they  are,  that  they  should  obey  the  law  of 
their  incorporation  and  not  bring  their  companies  to  the  verge  of 
bankruptcy  and  ruin  by  the  payment  of  quarterly  dividends  on  pre- 
ferred stock  out  of  capital  instead  of  net  earnings." 

It  might  be  added  that,  although  the  company  had  made  no 
allowance  for  depreciation,  the  point  was  not  raised  by  the 
plaintiffs,  and  the  court  was,  therefore,  not  called  upon  to 
pass  upon  it. 

The  EngHsh  Companies  (Consolidation)  Act,  1908  (8  Edw.  7, 
Ch.  69),  contains  the  following  provisions  with  respect  to  divi- 
dends and  reserves. 

Dividends  and  Reserve. 

TABLE  A. — Section  95.  The  company  in  general  meeting  may  de- 
clare dividends,  but  no  dividend  shall  exceed  the  amount  recommended 
by  the  directors. 

Section  96.  The  directors  may  from  time  to  time  pay  to  the  mem- 
bers such  interim  dividends  as  appear  to  the  directors  to  be  justified 
by  the  profits  of  the  company. 

Section  97.     No  dividend  shall  be  paid  otherwise  than  out  of  profits. 

Section  98.  Subject  to  the  rights  of  persons,  if  any,  entitled  to  shares 
with  special  rights  as  to  dividends,  all  dividends  shall  be  declared  and 
paid  according  to  the  amounts  paid  on  the  shares,  but  if  and  so  long 
as  nothing  is  paid  up  on  any  of  the  shares  in  the  company,  dividends 
may  be  declared  and  paid  according  to  the  amounts  of  the  shares.    No 


254  AUDITING. 

amount  paid  on  a  share  in  advance  of  calls  shall,  while  carrying  inter- 
est, be  treated  for  the  purposes  of  this  article  as  paid  on  the  share. 

Section  99.  The  directors  may,  before  recommending  any  dividend, 
set  aside  out  of  the  profits  of  the  company  such  sums  as  they  think 
proper  as  a  reserve  or  reserves  which  shall,  at  the  discretion  of  the 
directors,  be  applicable  for  meeting  contingencies,  or  for  equalizing 
dividends,  or  for  any  other  purpose  to  which  the  profits  of  the  company 
may  be  properly  applied,  and,  pending  such  appHcation,  may,  at  the 
like  discretion,  either  be  employed  in  the  business  of  the  company  or 
be  invested  in  such  investments  (other  than  shares  of  the  company)  as 
the  directors  may  from  time  to  time  think  fit. 

Section  100.  If  several  persons  are  registered  as  joint  holders  of 
any  share,  any  one  of  them  may  give  effectual  receipts  for  any  dividend 
payable  on  the  share. 

Section  lor.  Notice  of  any  dividend  that  may  have  been  declared 
shall  be  given  in  manner  hereinafter  mentioned  to  the  persons  entitled 
to  share  therein. 

Section  102.    No  dividend  shall  bear  interest  against  the  company. 

DEFINITION  OF  "PROFITS." 

In  connection  with  the  question  as  to  what  are  "  profits 
available  for  distribution,''  it  is  of  interest  to  note  the  definition 
given  in  Buckley,  8th  Edition,  pages  584  and  585,  which  is  as 
follows : 

"The  profits  of  the  business  of  the  company  are  the  credit  balance 
of  a  profit  and  loss  account  properly  prepared,  having  regard  to  the 
definition  of  the  business  in  the  memorandum  of  association.  They 
are  the  excess  of  revenue  receipts  over  expenses  properly  chargeable 
to  revenue  account.  As  to  what  expenses  are  properly  chargeable  to 
capital  and  what  to  revenue  it  is  necessarily  impossible  to  lay  down  any 
general  rule.  In  many  cases  it  may  be  for  the  shareholders  to  deter^ 
mine  this  for  themselves  provided  the  determination  be  honest  and 
within  legal  limits." 

It  will  probably  be  admitted  that  this  is  one  of  the  most 
diplomatic  definitions  that  has  ever  been  given  upon  a  sub- 
ject of  such  vast  importance ;  inasmuch  as  it  leaves  the  inquirer 
exactly  where  he  started,  for  it  still  remains  for  him  to  define 
what  receipts  are  apportionable  to  capital  and  what  to  revenue, 


255 

and  what  expenses  are  chargeable  to  capital  and  what  to  rev- 
enue. Could  these  questions  be  definitely  answered  in  each 
case,  it  is  obvious  that  the  question  of  what  the  actual  profits 
have  been  would  be  one  capable  of  the  most  ready  solution. 
In  view  of  the  close  relation  of  the  whole  subject  of  "  profits  " 
to  the  decisions  of  the  courts  it  becomes  necessary  to  ascertain 
the  legal  meaning  of  the  word.  In  many  undertakings  the 
judgment  of  the  professional  auditor  as  to  the  question  of 
actual  profits  may  differ  from  most  lawyers  but  it  'is  neverthe- 
less important  to  have  in  mind  all  that  may  be  said  on  the  sub- 
ject by  competent  authorities,  and  the  following  extract  from 
a  leading  law  text-book  (Cook  on  Corporations.  5th  Edition, 
page  1 164)  is  therefore  in  order: — 

"  In  view  of  the  rule  that  dividends  can  be  made  only  from  profits,  it 
becomes  important  to  ascertain  what  part  of  the  income  of  a  cor- 
poration constitutes  *  profits '  which  may  be  used  for  a  dividend.  This 
question  has  caused  the  courts  considerable  difficulty.  There  have 
been  various  definitions,  explanations,  and  different  states  of  fact  in- 
volved in  the  cases  which  have  come  before  the  courts.  The  Supreme 
Court  of  the  United  States  has  said  that  'the  term  "profits"  out  of 
which  dividends  alone  can  properly  be  declared,  denotes  what  remains 
after  defraying  every  expense,  including  loans  falling  due,  as  well  as 
interest  on  such  loans.'  An  English  court  says  that  profits  are  *the 
excess  of  the  current  gains  over  the  working  expenses  as  shown 
by  revenue  accounts  as  distinguished  from  capital  accounts.*  A  clear 
idea  of  what  constitutes  profits  available  for  dividends  can  be  obtained 
only  by  a  study  of  the  cases  themselves. 

"There  are  some  general  principles  connected  with  this  subject 
which  have  been  established  by  the  adjudications.  It  is  not  necessary 
for  a  railroad  or  other  corporation  to  use  its  profits  to  pay  its  funded 
or  bonded  debt  instead  of  using  those  profits  for  a  dividend.  But  it  is 
necessary  to  pay  the  interest  on  such  bonded  debt  before  any  dividend 
is  declared. 

"The  floating  debt  should  be  paid  or  funded  before  a  dividend  is 
declared.  A  corporation  often  owes  large  debts  and  still  has  its 
capital  stock  intact.  So  also  outstanding  and  disputed  claims  need  not 
be  first  paid. 

"A  proper  sum  must  first  be  expended  or  set  aside  for  repairs 
and  reconstruction  to  replace  depreciation  due  to  wear  and  tear.  In 
other  words,  the  fund  available  for  dividends  is  ascertained  by  taking 


256  AUDITING. 

into  account  the  cost  of  repairs  and  a  reasonable  allowance  for  depre- 
ciation, giving  credit  for  all  actual  permanent  improvements.  But  in 
the  case  of  a  company  owning  patent  rights,  or  of  a  mining  company 
whose  product  when  once  used  can  never  be  replaced,  it  is  not  neces- 
sary to  set  aside  funds  for  the  purpose  of  purchasing  new  patents  or 
a  new  mine. 

"  In  estimating  the  profits  for  a  year  for  the  purpose  of  declaring 
a  dividend,  it  is  not  necessary  to  take  into  account  the  decrease  in  the 
value  of  the  assets  and  the  impairment  of  the  capital  stock  of  the 
company  prior  to  that  year.  The  fact  that  in  a  year  prior  to  the 
declaration  of  the  dividend  some  portion  of  the  capital  has  been  lost 
and  has  not  since  been  made  good  affords  no  ground  for  restraining 
the  payment  of  a  dividend  out  of  profits  subsequently  earned.  A 
corporation  '  which  has  lost  part  of  its  capital  can  lawfully  declare  or 
pay  a  dividend  without  first  making  good  the  capital  which  has  been 
lost.'  Thus,  although  a  mining  company  for  several  years  is  obliged 
to  pay  the  interest  on  its  debts  out  of  the  capital  stock,  nevertheless 
in  subsequent  years,  when  large  profits  are  earned,  it  may  use  such 
profits  for  dividends  in  any  year  after  paying  the  interest  on  the  debt 
for  that  year.    The  company  need  not  first  restore  the  capital  stock. 

"  In  Connecticut  it  is  held  that  dividends  may  be  declared  on  pre- 
ferred stock  where  the  net  earnings  since  the  issue  of  the  stock  are 
sufficient,  even  though  prior  to  such  issue  the  capital  stock  had  been 
impaired,  but  that  ordinarily,  in  declaring  dividends,  the  directors  are 
not  justified  in  assuming  that  the  value  of  property  which  was  origin- 
ally received  in  pa3mient  for  stock  is  still  worth  that  value,  and  if  such 
property  at  the  time  of  the  dividend  was  not  actually  worth  the  par 
value  of  the  stock  which  was  issued  for  it,  the  dividend  is  illegal,  and 
a  director  receiving  such  dividend  as  a  stockholder  may  be  compelled 
to  pay  it  back  at  the  instance  of  a  receiver  of  the  corporation.  This 
rule  is,  of  course,  subject  to  statutory  restrictions,  as,  for  instance  in 
New  York  State,  where  dividends  can  be  made  only  from  *  surplus 
profits.'  A  dividend  may  be  declared,  although  the  company  has  not 
yet  completed  its  works.  In  the  case  of  railroads,  the  cost  of  addi- 
tional rolling  stock  and  improvements  may  be  charged  to  capital  ac- 
count, and  need  not  be  paid  before  a  dividend  is  declared.  Where  one 
company  buys  out  another  and  agrees  to  pay  a  certain  salary  to  an 
officer  of  the  latter,  or  a  lump  sum  in  lieu  thereof,  such  lump  sum,  if 
paid,  is  a  part  of  the  capital  stock,  and  need  not  be  considered  as 
expenses. 

"  Insurance  companies  cannot  declare  dividends  out  of  unearned 
premiums.     Banks   cannot   declare   dividends   out   of  interest  not  yet 


DEFINITION   OF   ''  PROFITS.'^  257 

received.     The  question  of  what  constitutes  profits  applicable  to  divi- 
dends arises  often  in  connection  with  preferred  stock." 

Another  legal  opinion  is  that  in  Richardson  v.  Buhl,  77 
Mich.,  67,2  (1889),  the  court  approving  of  the  following  state- 
ment : — ''  That  the  first  thing  to  be  done  by  any  manufacturer, 
who  would  ascertain  his  net  earnings  during  the  preceding 
year,  is  to  take  a  careful  inventory  of  what  he  has  left,  includ- 
ing his  plant  and  machinery,  and  then  make  just  and  full  allow- 
ances for  all  losses  and  shrinkages  of  every  kind  that  he  has 
suffered  in  his  property  during  the  year,  and  for  all  expenses 
of  every  kind,  ordinary  or  extraordinary,  that  have  occurred 
during  the  year;  and,  having  made  such  inventory,  and  de- 
ducted such  losses  and  shrinkage  of  every  kind,  his  net  earn- 
ings will  be  the  difference  between  all  his  investments  in  his 
business  and  all  his  expenses  of  every  kind  on  the  one  hand, 
and  this  new  inventory,  with  the  deductions  properly  made, 
and  all  that  he  has  received  of  every  kind,  on  the  other  hand ; 
and  if  his  books  are  properly  kept  and  proper  deductions  made, 
these  net  earnings  will  finally  appear  on  the  balance  sheet  to 
the  credit  of  the  profit-and-loss  account." 

The  foregoing  opinions  are  exceedingly  interesting,  and 
with  the  exception  of  a  few  of  the  statements  made,  corre- 
spond very  closely  with  the  rules  followed  by  the  best  Amer- 
ican practitioners. 

The  reference  to  the  necessity  for  charging  depreciation 
before  ascertaining  profits  available  for  dividends  should  be 
noted,  and  it  would  not  be  out  of  place  for  an  auditor  to  quote 
from  the  opinions  of  the  court  when  reporting  to  the  board  of 
directors  of  a  company  who  have  shown  a  disposition  to 
ignore  the  question  of  depreciation. 

It  would  seem  to  be  clearly  set  forth  in  the  law  books  and 
some  of  the  opinions  (even  if  not  specifically  stated)  that  de- 
preciation must  be  provided  for  in  ordinary  undertakings  be- 
fore the  fund  available  for  dividend  can  be  stated,  and  in  view 
of  the  decisions  in  the  ''Malting''  case  (as  bearing  upon  the 


258  AUDITING. 

necessity  of  profits  being  actually  earned  before  dividends  can 
be  paid)  reference  thereto  might  effect  a  change  in  the  minds 
of  some  directors,  more  particularly  with  respect  to  New  York 
and  New  Jersey  corporations. 

REVENUE  RECEIPTS. 

These  somewhat  exceptional  points  being  thus  disposed  of, 
the  right  conception  of  the  effect  of  more  ordinary  transactions 
may  now  be  considered.  For  this  purpose  it  will  be  convenient 
to  classify  the  various  items  appearing  upon  both  sides  of  a 
revenue  account,  which  in  the  aggregate  show  the  profit  alleged 
to  be  available  for  dividend.  Upon  the  credit  side  these  items 
may  be  conveniently  classified  under  the  following  headings : — 

(a)  Profit  on  transactions  completed  but  not  yet  received 

in  cash. 

(b)  Profit  on  transactions  not  completed,  whether  received 

in  cash  or  not. 

(c)  Profit  on  transactions  completed  and  received  in  cash. 

(d)  Profit  arising  from  an  estimated  rise  in  the  value  of 

fixed  or  floating  assets. 

(e)  Profit  not  properly  incidental  to  the  nature  of  the  busi- 

ness carried  on. 

With  regard  to  (a)  it  is  hardly  necessary  to  add  to  what 
has  been  already  said  in  the  preceding  chapters,  but  the  prin- 
ciples there  enunciated  may  be  summarized  as  follows: 

It  is  necessary  to  consider 

(i)  Whether  it  may  be  fairly  and  reasonably  anticipated 
that  the  debt  will  be  discharged  in  due  course. 

(2)  Whether  any  allowance   or   discount  is   likely   to   be 

claimed  when  the  debt  is  discharged;  and 

(3)  Whether  it  is  necessary  to  allow  for  the  loss  of  interest 

incidental  to  the  deferred  payment  of  such  debt. 


REVENUE  RECEIPTS.  259 

The  points  which  arise  on  (b)  have  already  been  very  fully 
considered  under  the  headings  of  "Work  in  Progress  "  and 
"  Goods  Sold  for  Future  Delivery."  It  is,  therefore,  unneces- 
sary to  go  further  into  detail  in  the  present  chapter.  It  may 
be  added,  however,  that,  in  the  case  of  financial  companies 
underwriting  issues  of  shares  or  bonds,  it  would  appear  to  be 
clearly  improper  to  take  credit  as  a  profit  for  any  commission 
upon  such  underwriting  in  respect  of  that  portion  of  the  issue 
which  had  been  allotted  to — and  still  remained  in  the  hands 
of — the  company  by  reason  of  the  subscriptions  from  the  gen- 
eral public  being  insufficient.  The  nature  of  an  underwriting 
agreement  is  that,  in  consideration  of  a  certain  commission, 
the  underwriter  agrees  to  take  a  certain  portion  of  the  issue  if 
the  pubHc  do  not  subscribe  enough  among  them  to  take  up  the 
whole  amount  among  themselves.  In  the  event  of  the  public 
subscriptions  being  insufficient,  therefore,  the  contract  has  the 
effect  of  the  underwriter  acquiring  a  certain  portion  of  the 
issue  at  a  discount ;  and  that  is  the  view  which,  it  is  submitted, 
the  auditor  should  take  of  the  transaction.  If  this  view  be 
adopted,  it  necessarily  follows  that  until  such  shares  or  bonds 
are  disposed  of  they  should  appear  as  an  asset  in  the  accounts 
of  the  underwriter,  not  at  their  face  value,  but  at  cost  price ; 
that  is  to  say,  the  underwriting  commission  should  be  dealt 
with,  not  as  a  profit,  but  as  a  reduction  from  the  actual  cost 
of  the  shares  or  debentures,  as  the  case  may  be.  A  fortiori 
if  assets  are  sold  for  payment  in  '*  paper,"  no  profit  should 
be  taken  credit  for  until  that  paper  is  actually  realized  in  cash. 

(d)  Although  it  was  held  in  one  English  case  and  is  the 
opinion  of  some  of  the  most  prominent  American  lawyers  that 
a  company  may  take  credit  for  an  assumed  rise  in  the  value 
of  its  floating  assets,  should  it  think  it  expedient  so  to  do,  it 
is  thought  that  accountants,  as  a  body,  will  be  more  inclined 
to  take  the  view  that  any  profit  arising  in  respect  of  dealing 
in  such  assets  should  only  be  taken  credit  for  in  the  period 
during  which  such  dealing  actually  occurs.  That  is  to  say, 
assuming  that  such  floating  assets  have  risen  in  value,  the 


260  AUDITING. 

proper  time  to  take  credit  for  the  profit  is  not  when  the  rise 
may  in  point  of  fact  have  occurred,  but  at  the  time  when  such 
assets  are  sold. 

The  views  referred  to  above,  however,  do  not  apply  to  an 
assumed  appreciation  in  the  value  of  -fixed  assets,  and  it  need 
not  be  urged  that  good  practice  would  never  permit  taking 
credit  for  the  apparent  profit  so  arising. 

Full  consideration  of  this  point  would,  however,  appear  to 
be  more  conveniently  dealt  with  under  the  following  heading: 

(e)  In  some  undertakings  it  may  happen  that  earnings  may 
airse  from  unusual  transactions,  and  the  question,  therefore, 
arises  as  to  the  proper  treatment  of  these  earnings. 

Leaving  upon  one  side  the  most  usual  source  of  profit  of 
this  description — ^viz.,  the  sale  of  a  portion  of  the  company's 
undertaking — which  has  already  been  dealt  with,  the  most 
ordinary  classes  of  profits  to  come  under  this  heading  would 
be  premiums  received  upon  stocks  or  bonds,  and  cash  which 
has  been  paid  on  shares  forfeited.  The  usual  custom  with 
both  these  sources  of  profits  is  to  credit  the  amount  to  reserve 
fund,  and  it  would  be  difficult  to  improve  upon  this.  But, 
at  the  same  time,  it  has  already  been  pointed  out  that — in  the 
absence  of  special  by-laws,  and  in  the  absence  of  a  by-law 
specially  so  providing — there  is  nothing  to  prevent  a  company 
transferring  the  whole,  or  a  portion,  of  its  reserve  fund  to 
profit  and  loss  account,  and  declaring  a  dividend  out  of  the 
increased  balance  so  available. 

REVENUE  EXPENSES. 

Turning  now  to  the  expenses  recorded  upon  the  debit  side 
of  the  revenue  account,  these  may  be  conveniently  classified 
under  the  following  headings : — 

(a)  Expenses  that  are  properly  chargeable  to  the  period 
under  review. 


REVENUE  EXPENSES.  261 

(b)  Expenses  which  may  properly  be  spread  over  a  term 

of  years. 

(c)  Undisclosed  and  contingent  liabiHties. 

(d)  Depreciation. 

(e)  Losses  arising  by  fluctuation  of  current  assets. 
(/)  Losses  arising  by  fluctuation  of  fixed  assets. 
(g)  Reserves  for  losses. 

(h)  Preliminary  expenses. 

With  regard  to  (a),  it  is  obvious  that  these  amounts  should 
all  be  charged  up  against  the  current  year's  revenue,  and  the 
steps  which  have  been  indicated  in  the  preceding  chapters 
should  be  taken  to  see  that  everything  coming  under  this  head- 
ing has  been  so  charged. 

(b)  It  should  be  remembered  that  the  onus  rests  upon  the 
directors  and  auditor  to  justify  this  class  of  expenditure  not 
being  included  as  a  charge  against  the  current  profits,  and 
that  the  auditor  must  therefore,  before  passing  the  accounts, 
satisfy  himself  as  to  the  sufficiency  of  the  reasons  advanced 
for  its  exclusion.  Examples  of  items  which  may  be  properly 
held  in  suspense  are  dead  rents  paid  in  excess  of  royalties  by 
colleries  and  similar  undertakings  where  there  is  reasonable 
ground  for  supposing  that  they  can  be  redeemed  out  of  future 
earnings,  and  also  special  expenditure  in  the  way  of  adver- 
tising some  new  venture  or  undertaking,  which  expenditure, 
it  is  estimated,  need  not  be  maintained  after  the  venture  has 
been  once  established.  With  regard  to  the  latter,  however, 
especial  care  is  necessary,  with  a  view  to  seeing  that  a  sufficient 
sum  is  written  off  annually,  as  it  not  infrequently  happens  that 
the  expectations  of  the  managers  are  not  realized,  and  that  the 
permanent  cost  of  advertising  is  far  more  than  has  been  antic- 
ipated. 

A  decided  stand  should  be  made  against  any  distribution 
over  future  years  of  ordinary  operating  expenses  merely  be- 


262  AUDITING. 

cause  they  may  be  of  unusual  amount.  If  the  accounts  of  a 
street  railway,  for  instance,  have  been  kept  without  making  any 
provision  for  depreciation  of  plant,  and  the  time  finally  arrives, 
as  it  is  bound  to  do,  when  it  is  necessary  to  make  extensive 
renewals,  it  is  manifestly  improper  to  carry  forward  any  part 
of  the  cost  of  such  renewals.  It  is  obvious  that  the  renewals 
are  due  to  past  operations — which  should  have  been  charged  at 
the  proper  time  with  the  expense  eventually  to  be  caused 
thereby — and  have  no  connection  whatever  with  future  opera- 
tions. The  foregoing  statements  do  not  apply  to  such  portion 
of  the  cost  of  renewals  or  replacements  as  might  represent  an 
improvement  in  type  or  increased  capacity  above  that  of  the 
construction  replaced;  such  portion  of  the  cost  could  quite 
properly  be  carried  forward. 

Nor  would  it  be  proper — to  use  another  illustration — in  the 
event  of  a  disastrous  accident  which  entailed  extraordinary 
large  disbursements  for  damages,  to  carry  forward  as  a  de- 
ferred charge  a  portion  of  such  disbursements  merely  because 
they  were  much  larger  than  usual  and  would  consequently  dis- 
turb the  continuity  of  the  results  ordinarily  shown.  As  the 
accident  is  an  incident  in  the  period's  operations  if  a  sufficient 
reserve  to  provide  therefor  does  not  exist,  the  income  of  the 
period  must  be  charged  with  the  expense  caused  thereby  and  it 
is  hardly  necessary  to  add  that  a  dividend  could  not  be  prop- 
erly declared  on  the  basis  of  an  income  account  which  omitted 
to  charge  a  considerable  sum  actually  disbursed,  or  for  which 
the  corporation  is  liable,  for  damages  incident  to  operation. 

It  is  unnecessary  to  add  anything  upon  either  (c)  or  (d) 
to  what  has  already  been  said  in  the  preceding  chapters,  where 
both  matters  have  already  been  very  fully  dealt  with. 

Passing  on  to  (^),  it  may  be  pointed  out  that,  inasmuch  as 
the  definition  of  "  current  assets  "  is  that  class  of  assets  which 
it  is  the  object  of  the  undertaking  to  convert  with  all  con- 
venient speed  into  cash,  it  is  obvious  that,  so  far  as  possible, 
nothing  in  excess  of  the  actual  current  market  value  should  be 


REVENUE  EXPENSES.  263 

attached  thereto  upon  the  face  of  any  balance  sheet,  and  the 
conservative  rule,  "  cost  or  market,  whichever  is  the  lower," 
followed.  Special  circumstances  may  occasionally  modify  this, 
where  at  the  moment  of  balancing  there  has  been  a  wholly 
unexpected  and  temporary  fall  in  value  which  has  been  recov- 
ered before  the  certifying  of  the  accounts.  It  is  probable, 
however,  that  it  is  only  in  connection  with  the  treatment  of 
foreign  exchanges  that  this  principle  can  generally  be  safely 
applied. 

(/)  Concerning  this  item,  it  is  thought  that,  so  long  as  the 
permanent  earning  capacity  of  the  fixed  asset  has  not  dimin- 
ished, it  is  quite  unnecessary  for  any  provision  to  be  set  aside, 
with  a  view  to  making  good  a  loss  which  may  have  occurred 
by  reason  of  the  fluctuation  of  the  value  of  such  assets.  Cer- 
tainly the  legal  decisions  which  have  been  given  in  England 
under  similar  circumstances  would  appear  to  support  this  view, 
and  the  quotation  from  "  Cook  on  Corporations  "  also  bears  it 
out.  It  is  important  to  remember,  however,  that  if  the  views 
already  expressed  with  regard  to  fluctuations  upwards  in  fixed 
assets  have  been  disregarded  and  credit  has  been  taken  for 
such  fluctuations  as  a  profit,  then  a  fortiori  it  is  necessary  that 
fluctuations  downwards  should  be  given  effect  to. 

(g)  With  regard  to  reserves  for  losses,  as  has  already  been 
pointed  out,  it  is  very  important  that  ample  reserves  should 
be  made  to  meet  all  reasonable  contingencies  before  allocating 
profit  for  purposes  of  payment  of  dividend.  The  only  thing 
that  appears  to  call  for  attention  here  is  that  in  some  cases 
— although,  of  course,  quite  improperly — what  is  really  a  re- 
serve against  loss  is  described  upon  the  face  of  a  balance  sheet 
as  a  "  Reserve  Fund  " ;  under  no  circumstances,  however,  must 
such  so-called  reserve  fund  be  encroached  upon  for  the  pur- 
pose of  equalizing  dividends,  unless  the  auditor  is  satisfied  that 
a  sufficient  balance  remains  to  meet  any  reasonable  expectation 
of  loss  that  may  occur. 


264  AUDITING. 

(h)  Under  almost  all  circumstances  it  will  be  found  usual 
to  write  off  a  portion  of  the  amount  incurred  by  a  company  in 
preliminary  expenses  say,  one-third  or  one-fifth,  in  each  year's 
accounts  until  the  amount  is  wholly  extinguished.  There  is 
no  compulsion,  however,  that  this  course  should  be  adopted, 
although  it  is  certainly  one  to  be  recommended ;  and  it  may 
be  added  that,  should  the  first  year's  accounts  show  a  loss,  it 
is  distinctly  preferable  not  to  obscure  the  actual  facts  of  the 
case  by  increasing  such  loss  by  writing  off  any  portion  of  the 
preliminary  expenses.  It  is,  of  course,  impossible  to  write 
them  off  except  out  of  profits,  and  the  attempt  should,  there- 
fore, not  be  made  upon  paper.  Per  contra,  where  there  is  a 
reserve  fund  and  the  accounts  for  the  current  period  show 
a  loss,  a  transfer  of  such  loss  should  be  made  to  the  debit  of 
reserve  fund,  so  far  as  the  latter  is  sufficient  for  the  purpose, 
it  being  a  contradiction  in  terms  to  state  a  loss  upon  one  side 
of  the  balance  sheet  and  a  reserve  fund  (i.  e.,  an  accumu- 
lation of  undivided  profits)  upon  the  other  side. 

In  Conclusion,  it  may  be  pointed  out  that  although  the 
"  cash "  basis,  as  applied  to  commercial  accounts,  is  in  the 
nature  of  things  most  fallible,  it  has  a  very  substantial  utility, 
as  applied  to  the  revision  of  the  results  arrived  at  by  means 
of  the  ordinary  revenue  account.  The  primary  object  of 
every  revenue  account  is,  of  course,  to  arrive  at  the  true  net 
profit  earned  during  the  period  under  review ;  but,  in  the  case 
of  the  vast  majority  of  undertakings,  by  no  means  the  least 
important  use  to  which  the  revenue  account  will  be  put  is  to 
determine  the  amount  of  such  profits  available  to  he  drawn  out 
of  the  business  and  distributed  among  the  proprietors  in  the 
case  of  a  company  or  a  partnership,  or  spent  by  the  sole  pro- 
prietor in  the  case  of  a  business  owned  by  an  individual.  The 
terms  "  net  profit "  and  "  profit  safely  divisible  "  are  by  no 
means  interchangeable ;  for  unless  the  working  capital  be  abun- 
dant, profits  cannot  be  prudently  drawn  out  of  the  business 
until  they  have  been  actually  realized  in  cash.  It  therefore 
follows  that,  in  the  great  majority  of  cases,  a  safeguard — and 


REVENUE  EXPENSES.  265 

at  the  same  time  an  easily  applied  rough  check  upon  the  accu- 
racy of  the  revenue  account — is  afforded  by  looking  at  the 
balance  sheet,  and  seeing  whether  it  would  be  practicable  to 
draw  out  of  the  business  the  whole  of  the  profits  alleged  to 
have  been  made,  and  whether  there  would  then  still  remain 
a  sufficient  balance  of  "  liquid  "  assets  available  to  meet  the 
ordinary  requirements  of  the  business.  Unless  such  a  suffi- 
ciency would  remain  after  dividing  profits  up  to  the  hilt,  it  is 
clear  that  such  profits  have  not  been  realized,  or  else  that  they 
have  been  diverted  from  their  proper  course  and  applied  as 
working  capital,  in  either  of  which  events  it  would  be  impos- 
sible to  distribute  them  without  causing  financial  embarrass- 
ment. 


CHAPTER  IX. 


THE  ATTITUDE  OF  THE  AUDITOR. 


In  the  foregoing  chapters  the  object,  extent  and  manner  of 
conducting  an  audit  have  been  dealt  with,  and  also — so  far  as 
the  space  at  disposal  permitted,  and  the  general  scope  of  this 
work  appeared  to  justify — such  modifications  of  and  depart- 
ures from,  the  normal  plan  as  are  necessary  to  adapt  it  to  the 
peculiar  requirements  of  any  individual  audit  with  which  the 
reader  is  Hkely  to  be  concerned.  The  position  of  the  auditor 
himself  will  now  be  more  particularly  considered. 

WHO  MAY  BE  AN  AUDITOR. 

Auditors  may,  for  general  purposes,  be  divided  into  three 
classes. 

(a)  Amateur  auditors. 

(b)  Professional  auditors. 

(c)  Official  auditors. 

It  may  be  well  to  say  a  few  words  about  each  class  before 
proceeding  further. 

AMATEUR  AUDITORS  are  a  class  to  whom  the  author 
has  no  great  desire  to  express  either  affection  or  respect.  He 
has  seen  too  much  of  their  shortcomings,  and  of  the  inexpress- 
ible misery  and  distress  that  have  been  caused  by  their  scan- 
dalous incompetency,  to  feel  any  desire  to  deal  gently  with 
their  failings.  Auditing  is  much  too  serious  a  matter  to  be 
trifled  with;  the  evil  that  can  be  wrought  by  an  incompetent 
auditor  is  hardly  less  vital — and  is  infinitely  more  extensive 

266 


WHO  MAY  BE  AN  AUDITOR.  267 

— ^than  that  which  may  be  exercised  by  an  unqualified  medical 
practitioner.  The  latter,  if  he  be  the  possessor  of  an  extensive 
practice,  might  possibly  poison  a  hundred  or  so  patients  in  the 
course  of  a  long  career ;  but  the  former  can,  while  merely  con- 
fining his  attentions  to  the  affairs  of  one  undertaking,  readily 
accomplish  the  ruin  of  thousands  and  the  starvation  or  suicide 
of  scores  in  a  much  shorter  period. 

Some  may  think  that  is  overstating  the  case,  and  will  say 
that  there  are  many  amateur  auditors  who  are  both  capable 
and  conscientious.  It  is  not  attempted  to  dispute  the  fact  that 
the  number  of  amateur  auditors  who  are  known  to  have  failed 
to  justify  the  confidence  reposed  in  them  is  altogether  insigni- 
ficant as  compared  with  the  number  who  are  still  discharging 
their  functions  to  the  satisfaction  of  all  concerned.  It  may, 
however,  be  remarked  that  "  the  satisfaction  of  all  concerned  " 
does  not  go  for  much;  the  auditors  of  a  host  of  disastrous 
undertakings  in  Great  Britain  and  the  United  States  exercised 
their  functions,  presumably,  "  to  the  satisfaction  of  all  con- 
cerned "  (especially  of  the  criminals)  until  the  moment  when 
the  crash  occurred;  and  it  is  worthy  of  note  that  the  crash 
never  does  occur  until  the  defalcator  has  taxed  his  milch-cow 
beyond  its  strength,  and  that  when  it  does  occur,  it  is  not  the 
amateur  auditor  who  has  brought  it  about.  In  fact,  until  the 
defaulter  is  fool  enough  to  kill  his  golden  goose,  the  amateur 
auditor  always  does  "  continue  to  discharge  his  functions  to 
the  satisfaction  of  all  concerned  " ;  but  does  that  prove  the  said 
auditor  to  be  discharging  his  functions  either  capably  or  con- 
scientiously ?     Assuredly  not. 

Again,  is  it  not  a  fact  that,  as  a  class,  amateur  auditors 
have  been  shown  (by  indisputable  statistics)  to  be  more  often 
concerned  in  cases  of  disaster  than  professional  auditors?  Is 
it  not  almost  invariably  the  case  that,  where  professional  audi- 
tors are  concerned,  they  have  themselves  detected  the  frauds, 
while  with  the  amateur  auditors  the  crash  almost  invariably 
comes  from  without? 


268  AUDITING. 

As,  however,  this  work  is  primarily  intended  for  the  use 
of  professional  auditors — to  whom,  alone,  the  perusal  of  any- 
book  upon  auditing  would  be  likely  to  confer  any  practical 
advantage — the  subject  need  hardly  be  pursued  further.  It 
is  of  interest,  however,  to  note  that,  while  the  number  of 
amateur  auditors  in  England  is  said  to  be  thinning  down  each 
year,  we  are  not  justified  at  present  in  making  a  similar  as- 
sertion to  cover  the  United  States. 

The  American  Association  of  Public  Accountants,  which 
includes  in  its  membership  practically  all  the  professional  ac- 
countants in  the  United  States,  does  not  yet  number  one  thou- 
sand members,  while  the  British  societies  number  at  least  seven 
thousand  members. 

When  we  consider  the  vast  number  of  corporations,  bene- 
ficial organizations,  savings  banks,  building  and  loan  societies, 
and  other  undertakings  where  the  accounts  are  submitted  each 
year  to  "  auditors,"  and  when  we  consider  further  that  the 
surety  companies  before  renewing  the  bonds  of  employees 
require  a  certificate  to  the  effect  that  the  accounts  have  been 
examined,  we  gain  some  idea  of  the  tremendous  aggregate  of 
amateur  auditing  which  is  being  done  at  the  present  time. 
The  appalling  number  of  defalcations  occurring  annually  may 
be  traced  largely  to  the  fact  that  the  audits  conducted  by  com- 
mittees of  stockholders  or  members  are  not  only  incomplete, 
but  the  very  fact  that  the  defaulter  knows  exactly  how  (Httle) 
his  accounts  will  be  investigated  gives  him  such  a  feeling  of 
security  in  his  manipulations  that  he  becomes  more  daring  and 
abstracts  larger  sums  than  if  no  audit  were  expected. 

As  was  stated  by  an  English  accountant  in  this  connection 
"  the  gentlemen  appointed  have  not  either  the  time,  the  incli- 
nation or,  so  to  speak,  the  machinery,  for  that  thorough  exam- 
ination which  we  know  to  be  essential  if  an  audit  is  to  be 
effectual  and  reliable."  Constant  agitation  of  the  inefficiency 
of  amateur  auditors  will  do  much  to  draw  the  attention  of  the 
business  public  to  the  danger  of  employing  them.     In  justice 


WHO  MAY  BE  AN  AUDITOR.  269 

to  the  amateur,  however,  it  must  be  said  that  his  duties  are 
frequently  thrust  upon  him,  and  many  of  them  would  gladly 
surrender  their  nominal  positions  of  honor  to  more  capable 
hands.  Many  substitutions  of  professional  auditors  have 
been  at  the  direct  solicitation  of  the  amateurs,  so  that  it  is 
hoped  that  by  a  simple  process  of  elimination  the  good  ones 
will  soon  go  of  their  own  accord  and  the  bad  ones  will  be 
superseded. 

Steps  in  this  direction  have  been  taken  by  many  corpora- 
tions and  societies  through  the  introduction  of  a  clause  in  their 
by-laws  requiring  the  employment  of  Certified  Public  Account- 
ants,  and  the  day  is  probably  not  far  distant  when  the  omis- 
sion of  such  a  requirement  will  be  the  subject  of  unfavorable 
comment  by  the  investing  public.  It  is  believed  that  the  con- 
trolling spirits  jn  our  corporations  and  societies  are  becoming 
sensitive  enough  on  this  point  to  warrant  the  hope  that  the 
practice  suggested  will  become  general  in  a  short  while. 

PROFESSIONAL  AUDITORS  are  a  class  with  whom  the 
reader  may  fairly  be  considered  to  be  well  acquainted.  Both 
on  account  of  their  special  training  and  on  account  of  the 
fact  that  their  energies  are  not  distracted  by  other,  and  dis- 
similar, occupations,  they  are  par  excellence  the  ideal  auditors. 
Moreover,  the  peculiar  facilities  they  possess,  in  the  shape  of 
a  large  staff  of  specially  trained  assistants,  place  them  in  the 
position  to  thoroughly  perform  audits  of  a  magnitude  that 
could  not  conscientiously  be  undertaken  by  any  one  man,  no 
matter  how  skilled. 

On  the  other  hand,  it  is  only  fair  to  state  that  while  an 
audit,  conducted  by  competent  and  responsible  professional 
accountants,  is  the  only  form  of  audit  that  can  reasonably  be 
expected  to  provide  those  safeguards  which  every  audit  ought 
to  secure,  there  are  some,  even  among  the  ranks  of  profes- 
sional accountants,  whose  chief  anxiety  appears  to  be  to  dis- 
claim any  such  measure  of  responsibility  for  their  work.  Thus 
it  has  been  asserted  in  one  quarter  that  "  he  is  the  worst  friend 


270  AUDITING. 

of  the  (accountancy)  profession  who  seeks  to  enlarge  the  re- 
sponsibilities of  auditors " ;  while  the  index  of  the  Eighth 
Edition  of  "  Auditors,  their  Duties  and  Responsibilities,"  by 
Mr.  F.  W.  Pixley,  F.C.A.,  does  not  comprise  any  such  words 
as  "  Defalcations,"  "  Fraud,"  or  "  Liabilities  of  Auditors  " — 
thus  clearly  showing  that,  although  these  matters  may  be  dealt 
with  incidentally  in  the  body  of  the  work,  they  are  regarded  as 
of  quite  second-rate  importance. 

It  is  quite  clear  that  under  no  circumstances  can  any  profes- 
sional audit  be  regarded  as  so  complete  a  safeguard  as  to 
constitute,  in  effect,  an  ''  insurance  "  against  fraud,  and  it  has 
been  expressly  held  by  the  English  Court  of  Appeal  that  an 
auditor  "  is  not  an  insurer."  There  is,  however,  a  vast  dif- 
ference between  holding  an  auditor  liable  as  an  insurer  and 
expecting  him  to  provide  such  reasonable  safeguards  as  will, 
under  normal  circumstances,  preserve  the  undertaking  against 
loss  owing  to  dishonesty.  Dealing  with  the  matter  first  of  all 
from  the  purely  commercial — and  therefore  from  the  lowest 
possible — standpoint,  the  minimum  premium  charged  by  an 
•insurance  company  for  a  guarantee  of  honesty  is  thirty  cents 
per  hundred  dollars,  and  a  higher  premium  is  almost  invari- 
ably charged  in  the  case  of  employees.  A  comparison  of  this 
figure  with  most  audit  fees  will  show  that,  if  any  credit  at  all 
is  to  be  given  for  the  actual  work  of  examining  the  accounts 
(which  work  is,  of  course,  never  performed  by  a  guarantee 
insurance  company),  little,  if  anything,  remains  to  cover  an 
"  insurance "  of  the  honesty  of  the  staff ;  while  a  slightly 
broader — and,  therefore,  more  common-sense — view  of  the 
situation  must,  of  course,  show  that  the  risks  which  insurance 
companies,  with  their  large  paid-up  capitals,  can  afford  to  run 
in  the  ordinary  course  of  their  business  are  far  different  from 
the  risks  that  any  individual  professional  man  could  prudently 
accept.  Thus,  on  the  grounds  of  law,  equity,  and  expediency 
alike,  it  is  clear  that  an  auditor  does  not  guarantee  his  client 
against  all  loss  by  dishonesty.  This,  however,  is,  it  need  per- 
haps hardly  be  pointed  out,  a  very  different  thing  indeed  from 


WHO  MAY  BE  AN  AUDITOR.  2/1 

an  entire  disclaimer  of  all  pecuniary  responsibility.  The  mere 
fact  of  an  auditor  attaching  his  signature  to  the  accounts  of 
an  undertaking,  qua  auditor,  is  a  distinct  "  representation  "  to 
all  whom  it  may  concern  that  the  accounts  in  question  have 
been  audited  by  him;  and  all,  therefore,  who  are  entitled  to 
rely  upon  this  representation  are  clearly  entitled  to  the  assur- 
ance (using  the  word  in  its  popular  sense)  that  the  work  al- 
leged to  have  been  performed  has  been  conducted  with  a  rea- 
sonable amount  of  skill  and  care.  The  exact  effect  of  this  "  as- 
surance "  in  each  separate  case  must,  of  course,  be  determined 
upon  the  merits  of  that  case;  but  the  safeguard  afforded  by 
this  personal  responsibility  of  the  auditor  is,  in  itself,  by  no 
means  a  negligible  quantity.  Further,  it  may  be  pointed  out 
that,  in  the  case  of  professional  auditors,  whose  living  de- 
pends upon  their  reputation  for  skill  and  care,  a  far  greater 
measure  of  security  is  provided  than  the  mere  legal  limit  of 
the  responsibility  of  the  auditor.  For  obvious  reasons  it 
would  be  inexpedient  to  strain  this  legal  responsibility  too  far, 
or  the  effect  would  inevitably  be  to  drive  men  of  substance 
out  of  the  profession;  the  chief  safeguard  of  a  professional 
audit,  and  its  great  superiority  over  an  amateur  audit,  lies 
thus  not  in  any  increased  measure  of  legal  responsibility  (for 
the  law  recognizes  no  distinction  between  professionals  and 
am.ateurs),  but  in  the  safeguard  afforded  by  the  fact  that  the 
professional  depends  for  his  livelihood  on  his  business  reputa- 
tion as  a  careful  and  skilful  auditor,  whereas  the  amateur  ob- 
viously does  not.  At  the  same  time  the  efforts  that  have  been 
made  in  some  quarters  to  reduce  the  legal  responsibilities  of 
auditors  to  "  vanishing  point "  cannot  be  too  strongly  depre- 
cated. 

OFFICIAL  AUDITORS  are  a  class  that  need  not  be  con- 
sidered here  at  any  great  length — the  author's  sole  object 
being  to  produce  a  work  of  practical  utility  to  the  profession. 

The  term  "  official  auditors  "  as  used  here  includes  all  those 
who  are  employed  to  audit  the  accounts  of  state  and  muni- 
cipal authorities,  as  well  as  those  appointed  by  the  courts  of 


27^  AUDITING. 

the  various  states  to  examine  and  pass  upon  the  accounts  of 
decedents'  estate,  &c.  The  latter  are  almost  invariably  law- 
yers, and  the  most  important  part  of  their  duty  appears  to  be 
to  scrutinize  the  various  transactions,  with  a  view  to  seeing 
that  they  are  not  ultra  vires.  This  is,  of  course,  a  very  impor- 
tant matter,  but  it  is  to  be  regretted  that  the  attention  of  offi- 
cial auditors  should  be — as  in  point  of  fact  it  is — almost  en- 
tirely restricted  to  a  scrutiny  of  the  accounts  from  this  point 
of  view,  with  the  result  that,  although  the  accounts  are  sup- 
posed to  be  checked  with  a  view  to  detecting  error  and  fraud, 
it  has  frequently  transpired  that  dishonesty  has  remained  un- 
discovered for  a  very  considerable  period,  and  that  the  ac- 
counts themselves  are  grossly  inaccurate  in  essential  particu- 
lars. It  is  suggested  that,  for  the  accounts  of  estates,  &c.,  to  be 
really  effectively  audited,  the  investigation  of  the  official  audi- 
tors, with  their  legal  training,  should  be  confined  to  a  scrutiny 
of  the  various  transactions  from  this  point  of  view,  the  actual 
verification  of  the  accounts  themselves  being  performed  by 
professional  auditors,  who  by  their  training  are  far  better  quali- 
fied than  any  lawyer  to  detect  both  errors  in  accounting  and 
dishonesty  on  the  part  of  those  having  the  handling  of  money. 
This,  it  is  thought,  is  the  true  solution  of  the  difficulty;  but, 
because  these  matters  are  frequently  settled  on  party  lines,  and 
rarely  on  their  merits,  it  is  not  likely  to  be  adopted. 

Still  another  class  of  official  auditors  includes  various  em- 
ployees of  national  and  state  departments  who  almost  invari- 
ably secure  their  positions  through  political  influence,  but  upon 
whom  devolves  a  vast  amount  of  work  which  more  properly 
belongs  to  professional  auditors.  It  is  altogether  likely  that  the 
inefficiency  of  many  of  these  men  will  lead  to  reforms  in  this 
direction  which  cannot  help  increasing  the  scope  and  responsi- 
bility of  the  work  of  the  Certified  Public  Accountant. 

It  must  be  taken  into  consideration,  however,  that  official 
auditors  usually  work  under  disadvantages  in  that  they  are  not 
only  limited  as  to  the  scope  of  their  examinations,  but,  fur- 


WHO  MAY  BE  AN  AUDITOR.  273 

thermore,  the  time  at  their  disposal  is  ordinarily  too  limited  to 
admit  of  a  thorough  audit  in  most  cases. 

A  case  in  point  is  that  of  one  of  our  large  insurance  com- 
panies, having  over  four  hundred  millions  of  assets,  which 
had  been  "  audited  "  regularly  by  the  *'  Auditors  "  of  the  State 
Insurance  Department,  whose  report  had  uniformly  been  fa- 
vorable. Disclosures  of  gross  irregularities  from  within  occa- 
sioned a  more  searching  examination  on  the  part  of  a  commit- 
tee of  directors,  as  well  as  an  additional  examination  by  the 
State  Department.  Both  of  these,  however,  proved  ineffectual, 
and,  common-sense  finally  prevailing,  two  leading  firms  of 
Certified  Public  Accountants  were  engaged,  and  a  general 
feeling  immediately  prevailed  that  the  actual  condition  of  the 
company  in  question  would  at  last  be  ascertained. 

The  more  prominent  of  the  official  auditors  included  in  the 
last  class  include  National,  State  and  Clearing  House  Bank 
Examiners,  State  Auditors  employed  by  the  Departments  of 
Insurance,  Charities,  &c.,  and  Examiners  connected  with  the 
Bureau  of  Corporations  of  the  Department  of  Commerce  and 
Labor. 

In  recent  years  there  has  been  a  strong  tendency  towards 
Government  supervision,  with  the  consequence  that  the  num- 
ber of  "  official "  auditors  has  greatly  increased,  and  in  all 
likelihood  the  accessions  to  the  ranks  will  continue.  It  is  not 
proposed  to  criticise  nor  even  discuss  the  work  done  by  these 
officials,  but  it  is  not  out  of  place  to  call  attention  to  the  fact 
that  the  salaries  attached  to  the  positions  are,  for  the  most 
part,  considerably  too  low  to  attract  first-class  men. 

There  are,  therefore,  two  reasons  at  least  why  official  audi- 
tors are  not  so  competent  as  professional  auditors,  one  being 
the  fact  that  many  of  the  appointments  are  in  payment  of 
political  debts,  with  the  consequent  result  that  wholly  inexpe- 
rienced and  incompetent  men  are  frequently  chosen;  and,  sec- 
ondly, even  if  the  places  were  filled  solely  upon  the  basis  of 
merit,  it  is  not  to  be  expected  that  capable  men  will  be  found, 


274  AUDITING. 

in  any  great  number  at  least,  occupying  positions  of  great  re- 
sponsibility but  with  small  salaries  attached. 

THE  AUDITOR'S  QUALIFICATIONS. 

Upon  this  point  a  considerable  quantity  of  professional  lit- 
erature already  exists.  The  subject  has  been  touched  upon  in 
a  great  number  of  addresses  and  magazine  articles.  It  is  not, 
therefore,  proposed  to  consider  the  subject  at  any  great  length 
(for,  there  being  no  essential  difference  of  opinion  upon  the 
matter,  such  a  course  appears  to  be  uncalled  for),  but  rather 
to  briefly  indicate  the  qualities  that  go  to  make  an  efficient  and 
a  successful  auditor. 

First,  then,  it  is  very  generally  conceded  that  an  exhaustive 
knowledge  of  every  department  of  bookkeeping  is  the  very 
"  A  B  C  "  of  the  auditor's  art. 

Second  in  importance,  probably,  is  a  thorough  acquaintance 
with  various  statutes  regulating  the  different  undertakings  in 
which  the  auditor  may  be  concerned. 

Thirdly,  although  this  point  has  been  bitterly  contested  by 
some,  a  sufficient  knowledge,  not  only  of  business  generally, 
but  of  the  especial  way  in  which  various  particular  businesses 
are  conducted.  As  was  expressed  by  an  English  ac- 
countant some  years  ago :  "  No  accountant  can  suc- 
cessfully carry  on  his  practice  in  all  the  above-mentioned 
branches  unless  he  is  a  person  of  considerable  knowledge,  skill, 
and  experience,  for  he  must  be  not  only  acquainted  with  book- 
keeping, which  is  to  him  as  the  alphabet  only;  but,  to  put  it 
very  briefly,  he  must  have  some  general  knowledge  of  various 
trades  and  their  customs.  .  .  .  He  ought  also  to  have 
some  knowledge  of  the  practice  of  the  Stock  Exchange,"  and 
so  on.  No  unprejudiced  person  would  deny  the  advantage 
of  such  a  knowledge  as  is  here  advocated;  the  only  question 
being  whether  the  standard  set  is  so  high  as  to  be  virtually 
unattainable,  and^  consequently,  impracticable.  The  reply  to 
this  is  that,  in  accountancy,  as  elsewhere,  it  is  only  he  who 


AUDIT   CLERKS.  275 

aims  at  absolute  perfection  who  can  expect  to  attain  even  to 
a  decent  mediocrity.  A  complete  knowledge  of  everything-  is 
not  readily  attained  in  threescore  years  and  ten,  and  is  not 
expected  as  the  result  of  the  limited  period  of  study  preceding 
the  various  State  examinations.  Only  let  the  accountant  make 
the  most  of  his  opportunities — and  he  will  find  that  his  general 
practice,  as  well  as  audits,  will  afford  him  many — and  he  will 
be  surprised  at  the  amount  of  knowledge  he  can  acquire,  even 
in  a  short  time,  and  perhaps  even  more  astonished  at  the  vast 
amount  of  service  such  knowledge  will  be  to  him  in  his 
profession. 

Lastly,  but  not  least,  may  be  placed  those  desirable  qualifi- 
cations of  the  auditor  which  are  not  acquired  by  careful  study, 
but,  rather,  by  living.  Tact,  caution,  firmness,  fairness,  good 
temper,  courage,  integrity,  discretion,  industry,  judgment,  pa- 
tience, clear-headedness  and  reliability.  In  short,  all  those 
qualities  that  go  to  make  a  good  business  man  contribute  to 
the  making  of  a  good  accountant;  while  that  judicious  and 
liberal  education  which  is  involved  in  the  single  word  "  cul- 
ture "  is  most  essential  for  all  who  would  excel.  Accountancy 
is  a  profession  calling  for  a  width  and  variety  of  knowledge 
to  which  no  man  has  yet  set  the  limit;  the  foremost  account- 
ants are  not  ashamed  to  say  that,  like  Epaminondas,  they 
"  learn  something  in  addition  every  day  " ;  let  us,  therefore, 
see  no  shame  in  following  their  example. 

AUDIT  CLERKS. 

It  will  not  be  amiss,  before  leaving  this  subject,  to  con- 
sider, very  briefly,  the  desirable  qualifications  of  an  audit  clerk. 
Conscientiousness  may  be  placed  in  the  foremost  rank.  A 
large  amount  of  uninteresting  detail  must  inevitably  form  a 
part  of  the  clerk's  daily  routine ;  and  the  fact  that  the  greater 
portion  of  such  work  may  generally  be  "  skimped,"  without 
any  great  danger  of  detection,  affords  considerable  tempta- 
tion, both  to  the  naturally  slow  worker  and  to  the  gentleman 
of  elastic  conscience  who  wishes  to  make  a  little  time  for 


276  AUDITING. 

himself.  Reliability  is  the  first  requisite  in  a  clerk,  and  the 
clerk  who  wishes  to  get  on  must  endeavor  to  earn  a  reputation 
for  being  "  safe."  Next,  the  clerk  would  be  wise — especially 
the  young  clerk — not  to  get  too  friendly  with  his  client's  staff. 
Let  him  be  cautious  of  accepting  favors,  and  most  cautious  of 
accepting  presents — which  might  easily  drift  into  bribes.  In 
this  respect  clerks  may  sometimes  find  themselves  in  a  very 
difficult  position  (more,  perhaps,  from  force  of  circumstances 
than  from  weakness  of  character),  and  the  possibility  of  such 
an  occurrence  adds  another  reason  to  those  mentioned  in  the 
first  chapter,  to  the  desirability  of  occasionally  changing  the 
rounds  of  the  audit  clerks.  Imagination  (under  proper  con- 
trol) is  another  very  desirable  quality  in  a  clerk;  for,  with- 
out it,  he  is  apt  to  become  a  mere  machine  and  consequently 
next  to  absolutely  useless  to  the  auditor. 

THE  AUDITOR'S  POSITION. 

The  position  of  the  auditor  varies  to  a  certain  extent  with 
the  nature  of  his  appointment,  and  it  will,  therefore,  be  well  to 
consider  the  circumstances  separately. 

THE  AUDITOR  TO  AN  INDIVIDUAL  will,  in  almost 
every  instance,  receive  his  appointment  from  such  individual 
in  person;  the  appointment  being — in  the  absence  of  stipula- 
tion to  the  contrary — for  the  period  covered  by  the  revenue 
account,  but  renewable  upon  the  same  terms  for  each  suc- 
cessive period,  unless  a  contrary  agreement  be  made.  The 
fee  for  the  first  audit  is  sometimes  settled  beforehand,  but 
more  usually  left  open  until  the  time  occupied  has  been  as- 
certained, the  fee  for  subsequent  audits  being  usually  arranged 
after  the  completion  of  the  first  audit.  Naturally,  the  fee 
charged  will  be  a  matter  of  arrangement ;  but,  in  the  event  of 
no  definite  sum  having  been  settled,  the  auditor  would — in  a 
case  of  disagreement — ^be  entitled  to  such  sum  as  a  jury  would 
award,  which  would  probably  be  the  usual  professional 
charges.  There  would  be  no  especial  limit  to  the  responsibili- 
ties of  an  auditor  to  a  sole  trader  or  manufacturer;  if  he 


THE  auditor's  POSITION.  2// 

certify  a  set  of  accounts  as  correct,  any  third  party  {e.  g.,  a 
bank  advancing  money)  relying  upon  his  certificate  would 
probably  have  exactly  the  same  right  to  expect  the  accounts 
to  be  accurate  as  though  the  audit  had  been  performed  in 
pursuit  of  their  own  instructions.  This  is  a  point  that  should 
not  be  lost  sight  of,  as  one  is  very  apt  to  reply  upon  the  un- 
supported word  of  one's  own  client.  At  the  same  time,  there 
is  no  reason  why  partial  audits  (the  results  of  which  are  not 
certified)  should  not  be  made  in  the  case  of  individuals  or 
firms,  provided  there  is  a  clear  understanding  between  the 
client  and  the  auditor  as  to  the  extent  of  the  latter's  examina- 
tion. An  auditor  may  resign  his  office  at  any  time,  but  it  is 
doubtful  whether  he  could  then  claim  to  be  paid  for  the  time 
occupied  upon  an  uncompleted  audit.  On  the  other  hand,  the 
client  may  at  any  time  discharge  his  auditor,  but  he  would 
probably  be  held  liable  for  the  whole  fee  of  the  current  period, 
if  the  audit  had  been  actually  commenced. 

THE  AUDITOR  TO  A  FIRM  is  usually  appointed  by  the 
mutual  agreement  of  the  partners;  but,  occasionally,  by  the 
articles  of  partnership  themselves,  or  by  one  particular  part- 
ner. If  appointed  auditor  to  the  firm,  he  must,  however,  in 
every  case,  consider  each  partner  as  his  client,  and  protect  the 
interests  of  each  accordingly.  The  same  conditions  as  to  terms 
of  agreement,  responsibility,  fees  and  resignation,  obtain  to 
the  auditorship  of  firms  as  were  mentioned  in  the  previous 
paragraph;  but  it  would  seem  that  any  one  partner  would 
have  power  to  bind  the  firm  as  to  the  amount  of  the  fees— 
except,  perhaps,  where  the  appointment  lay  in  the  hands  of 
one  partner,  when  the  consent  of  such  partner  would  prob- 
ably be  required.  Probably  no  one  partner  could  discharge 
an  auditor  without  the  consent  of  all  his  co-partners. 

This  seems  the  proper  place  to  point  out  that  in  practice  it 
not  infrequently  happens  that  the  letter,  if  not  the  spirit,  of 
partnership  agreements  is  broken  from  time  to  time;  and,  so 
far  as  these  infractions  of  the  agreement  relate  to  accounts, 
it  is  clearly  the  duty  of  the  firm's  auditor  to  draw  attention 


278  AUDITING. 

to  the  position  of  affairs  in  his  report.  The  most  usual  irregu- 
larity of  this  description  is  for  one  or  more  of  the  partners 
to  exceed  the  amount  which  they  are  entitled  to  draw  on  ac- 
count of  profits;  and,  although  this  overdrawing  need  not 
necessarily  imply  bad  faith  upon  the  part  of  the  partner  con- 
cerned, it  is  important  for  the  auditor  to  draw  attention 
thereto,  if  only  for  the  sake  of  equitably  adjusting  the  respec- 
tive interests  of  the  partners.  Even  where  the  partnership 
articles  do  not  provide  for  interest  upon  either  capital  or  draw- 
ings, it  would  be  well  to  point  out  that,  as  a  matter  of  equity, 
it  is  desirable  that  interest  should  be  charged  upon  any  excess 
of  drawings  over  the  authorized  amount,  inasmuch  as  these 
are  clearly  in  the  nature  of  a  loan  from  the  firm  to  the  indi- 
vidual partner,  and  should,  therefore — as  a  matter  of  right — 
carry  interest  in  exactly  the  same  way.  In  England  the  law 
provides  that  loans  from  the  partners  to  the  firm  shall  carry 
interest  at  the  rate  of  five  per  cent,  in  the  absence  of  express 
stipulation  to  the  contrary.  Any  irregularities  of  this  descrip- 
tion should,  therefore,  be  reported  to  all  the  partners;  and,  as 
a  matter  of  convenience,  it  would  appear  to  be  desirable  that 
such  report  should  precede  the  actual  closing  of  the  accounts, 
so  that  the  instructions  of  the  firm  may  be  taken  upon  the 
point  and  given  effect  to  before  the  audit  is  completed.  It  is 
very  desirable  for  the  auditor  to  see  that  the  accounts,  after 
being  finally  agreed  to,  are  signed  by  all  the  partners. 

THE  AUDITOR  ON  BEHALF  OF  CREDITORS.— It 
not  infrequently  occurs  that  a  retiring  partner,  who  leaves  a 
portion  of  his  capital  in  the  firm,  or  a  creditor  who  makes  an 
advance  to  a  firm,  stipulates  that  "  Mr.  So-and-so  shall  audit 
the  accounts."  Unless  the  contrary  intention  be  very  clearly 
expressed,  the  auditor  so  appointed  would  act  on  behalf  of 
both  the  firm  and  the  creditor.  In  such  a  case  it  is  very  de- 
sirable that  the  amount  of  the  fee  be  arranged  beforehand,  and 
it  would  not  be  wise  to  leave  it  an  open  question  as  to  who 
was  to  pay  it.  Under  the  circumstances  the  firm  could  not, 
of  course,  remove  the  auditor  without  the  consent  of  the  credi- 


THE  auditor's  POSITION.  279 

tor;  nor,  in  the  absence  of  a  special  provision  to  that  effect, 
could  the  creditor  do  so,  and  in  any  case  he  would  probably 
be  obliged  to  indemnify  the  firm  against  any  extra  expense 
occasioned  by  his  so  doing.  The  position  of  the  auditor,  in 
such  a  case  as  this,  closely  resembles  that  of  the  company  audi- 
tor, except  that  the  creditor  would  be  entitled  to  the  fullest 
possible  information,  while  it  is  sometimes  a  question  as  to 
whether  stockholders  have  an  equally  extensive  right. 

In  the  fourth  English  edition  of  this  work  attention  was 
drawn  to  a  serious  abuse  in  connection  with  company  pros- 
pectuses. These  frequently  put  forward  the  name  of  a  certain 
firm  as  the  auditors  of  a  company;  but  although  the  putting 
forward  of  a  firm  as  auditors  in  this  manner  implies  a  certain 
measure  of  responsibility — moral  if  not  legal — it  conveyed  to 
the  firm  in  question  no  security  that  the  directors  of  the  com- 
pany would  subsequently  confirm  the  appointment.  This, 
however,  has  now  been  remedied  by  a  provision  in  the  English 
Companies  Act,  1900,  which  requires  every  director  to  sign  the 
prospectus  before  it  is  published.  The  directors  thus  become 
responsible  for  the  accuracy  of  a  statement  that  the  firm 
named  are  the  auditors  of  the  company.  In  the  United  States 
it  has  not  been  customary  to  mention  the  names  of  proposed 
auditors,  but  certain  recent  events  warrant  the  belief  that  this 
step  will  practically  be  forced  upon  company  promoters  here- 
after, or  the  investing  public  will  not  be  so  keen  to  purchase 
the  securities  offered. 

THE  AUDITOR  OF  COMPANIES  other  than  those  un- 
der national  or  state  regulation  is  subject  to  the  rules  and 
regulations  of  the  company  concerned,  and  to  such  further 
statutory  provisions,  if  any,  as  may  apply  to  the  particular 
class  of  undertaking.  The  usual  practice  is  for  him  to  be  ap- 
pointed by  the  directors,  although  in  many  instances  he  is  re- 
tained by  the  officers. 

While  it  may  seem  rather  far  fetched  to  criticise  an  officer 
of  a  company  for  securing  the  services  of  a  professional  audi- 


28o  AUDITING. 

tor,  particularly  where,  as  is  frequently  the  case,  the  stockhold- 
ers and  directors  exhibit  no  interest  whatever  in  the  matter, 
yet  an  appointment  under  such  circumstances  is  frequently  re- 
sponsible for  placing  the  auditor  so  engaged  in  an  unenviable 
position.  It  is  not  unnatural  that  a  president,  or  a  treasurer, 
who  has,  of  his  own  volition,  departed  from  the  past  policy 
of  his  company  and  called  in  a  professional  auditor,  should 
feel  some  resentment  if  his  own  acts  when  under  review  do 
not  meet  with  the  approval  of  the  auditor.  This  resentment 
is  even  more  marked  when  the  auditor  has  received  the  ap- 
pointment largely  as  a  matter  of  friendship  (which  is  also  of 
frequent  occurrence),  and  the  acts  of  his  sponsor  are  made 
the  subject  of  criticism.  It  is  expected  that  the  custom  of  an 
auditor  being  appointed  by  the  stockholders,  as  provided  by 
the  English  Companies  Act,  will  shortly  extend  to  the  United 
States,  and  instead  of  the  practice  being  followed  by  perhaps 
a  dozen  or  two  American  companies,  as  is  now  the  case,  all 
or  nearly  all,  of  our  corporations  will  shortly  have  a  by-law 
containing  this  requirement. 

It  would  seem  that  the  shortest  way  to  bring  about  such  a 
desirable  state  of  affairs  would  be  by  amending  the  general 
corporation  acts  of  the  several  States,  and  it  is  hoped  that  such 
legislation  will  shortly  be  instituted. 

In  this  connection  it  is  of  interest  to  note  the  following  bill, 
which  was  introduced  in  the  1905  session  of  the  Pennsylvania 
Legislature  at  the  request  of  the  President  of  the  Pennsyl- 
vania C.  P.  A.  Board : — 

AN  ACT. 

Requiring  the  certification  of  a  Certified  Public  Accountant  of  the 
State  of  Pennsylvania,  as  to  the  correctness  of  any  financial  state- 
ment issued  by  any  corporation  of  this  State  or  by  any  foreign  cor- 
poration or  corporation  of  other  States,  doing  business  in  the  State 
of  Pennsylvania,  for  public  information  or  for  purposes  of  taxation, 
and  to  provide  a  punishment  for  the  violation  of  this  act. 

Section  i.  Be  it  enacted  by  the  Senate  and  House  of  Representatives 
of  the  Commonwealth  of  Pennsylvania  in  General  Assembly  met  and 


THE  auditor's  POSITION.  281 

it  is  hereby  enacted  by  the  authority  of  the  same,  that  all  corporations 
of  the  State  of  Pennsylvania  or  foreign  corporations  or  corporations 
of  other  States,  doing  business  in  the  State  of  Pennsylvania,  upon 
issuing  any  financial  statement  inviting  the  purchase  of  their  stock  or 
bonds,  or  in  issuing  any  monthly,  quarterly,  semi-annual  or  annual 
statements  of  the  condition  or  business  of  such  corporations,  or  any 
financial  statements  given  to  the  newspapers,  financial  agencies,  or 
other  financial  statements  for  the  purpose  of  pubHc  information  in  the 
State  of  Pennsylvania  or  upon  furnishing  statements  to  the  officials  of 
the  State  of  Pennsylvania,  for  the  purpose  of  taxation,  shall  be  re- 
quired to  have  such  statements  verified  by  a  Certified  Public  Account- 
ant of  the  State  of  Pennsylvania. 

Sec.  2.  If  any  such  corporation  fails  to  have  such  certification  made 
it  shall  be  deemed  and  held  guilty  of  a  misdemeanor,  and  upon  con- 
viction thereof  shall  be  fined  not  more  than  one  thousand  dollars,  nor 
less  than  five  hundred  dollars,  and  any  officer,  agent  or  employee  of 
such  corporation  furnishing  a  false  statement,  or  any  Certified  Public 
Accountant  certifying  to  the  correctness  of  a  statement  issued  by  any 
corporation,  when  it  is  vitally  incorrect  or  misleading,  the  officer, 
agent  or  employee  making  such  false  statement,  and  the  Certified 
Public  Accountant  certifying  to  such  false  statement  shall  be  deemed 
guilty  of  a  misdemeanor,  and  on  conviction  thereof  shall  be  sentenced 
to  imprisonment  for  a  term  not  exceeding  two  years  and  not  less  than 
one  year,  or  a  fine  not  exceeding  five  thousand  dollars,  nor  less  than 
three  thousand  dollars,  or  both. 

It  is,  perhaps,  needless  to  add  that  the  bill  did  not  pass.  It 
was  contended  by  some  accountants  that  it  was  too  drastic  and 
that  a  statute  requiring  the  certification  of  a  Certified  Public 
Accountant  to  the  annual  statements  of  corporations  would  be 
of  more  real  value  than  any  attempt  to  compel  more  frequent 
examinations. 

Unless  the  remuneration  of  the  auditor  is  fixed  at  the  time 
of  his  appointment,  he  is  entitled  to  reasonable  remuneration; 
but  if  the  by-laws  provide  that  he  shall  be  appointed  at  the 
annual  meeting  and  receive  "  such  remuneration  as  the  stock- 
holders may  think  fit/'  he  is  entitled  to  such  sum  as  the  gen- 
eral meeting  may  award  him — and  no  more.  Directors  have 
no  power  to  dismiss  an  auditor,  if  once  appointed;  but,  ap- 
parently, an  auditor  may  resign  at  any  time,  although  probably 


282  AUDITING. 

at  the  loss  of  his  fees  for  the  uncompleted  work.  If  appointed 
by  the  stockholders  a  casual  vacancy  can  be  filled  by  an  ap- 
pointment at  an  extraordinary  general  meeting,  but  usually  the 
directors  would  have  power  to  fill  a  casual  vacancy. 

To  a  great  extent  it  rests  with  the  directors  to  decide  how 
much  information  shall  be  supplied  in  the  published  accounts, 
but  the  auditor  must  not  lose  sight  of  his  individual  respon- 
sibility. He  should  be  particularly  careful  to  guard  against 
juggling  with  words,  and  so  appearing  to  give  a  full  certi- 
ficate, when  in  reality  he  is  "  making  himself  safe,"  or  *'hedg- 
ing  "  behind  a  certificate  which,  when  carefully  analyzed  (and 
only  then),  is  found  to  be  most  qualified.  He  must,  in  every 
case,  be  satisfied  in  his  own  mind  that  the  accounts  are  correct, 
and  fairly  stated. 

RESIGNATION  OF  AUDITORS.— There  is  nothing 
whatever  in  connection  with  this  subject  in  the  English  Com- 
panies Acts,  1862-1908,  nor  in  any  of  our  own  corporation  laws. 
Any  right  that  the  auditor  may  have  to  resign  is,  therefore, 
entirely  founded  upon  custom.  It  is  not  for  a  moment  dis- 
puted that  an  auditor  would  at  any  time  have  a  right  to 
resign  his  position,  and  were  he  to  do  so  the  "  casual  vacancy  " 
which  is  referred  to  in  the  English  Acts  would,  of  course, 
arise;  but  it  is  surprising  that  the  matter  should  not  be  dealt 
with  more  explicitly. 

A  point  of  considerable  interest  to  all  accountants  is  the 
question  as  to  what  an  auditor  ought  to  do  when  he  finds  him- 
self in  hopeless  disagreement  with  the  directors  upon  a  ques- 
tion as  to  what  ought  to  be  done  in  the  way  of  treating  certain 
items  in  the  company's  accounts.  Only  too  frequently  the 
course  adopted  is  for  the  auditor  to  resign,  so  that  the  directors 
can  fill  up  the  casual  vacancy  thus  caused,  by  appointing  some 
one  who  happens  to  agree  with  their  own  view,  and  so  the 
whole  matter  is  hushed  up,  and  never  comes  to  the  knowledge 
of  the  stockholders  at  all.  It  is  obvious  that  this  procedure 
effectually  detracts  from  the  independence  of  an  audit.     If 


THE  auditor's  POSITION.  283 

there  is  any  advantage  at  all  in  having  an  auditor,  independent 
of  the  management,  to  supervise  the  accounts  of  a  company, 
it  is  that  in  the  event  of  his  discovering  anything  which  he 
thinks  should  come  to.  the  knowledge  of  the  stockholders,  then 
that  something  will  be  placed  before  them.  Under  the 
circumstances  existing  prior  to  the  passage  of  the  Com- 
panies Act  of  1908,  it  was  probably  not  once  in  ten  times  that 
an  occurrence  of  this  kind  was  ever  found  out  by  the  stock- 
holders. All  that  they  knew  was  that  the  accounts  had  been 
audited.  They  had  probably  quite  forgotten  the  name  of  the 
previous  auditor,  and  no  intimation  was  made  to  them  of  the 
fact  that  a  change  had  occurred. 

The  Companies  Act  of  1908,  however,  has  remedied  this 
condition  to  a  very  considerable  extent  as  far  as  our  English 
brethren  are  concerned.  This  act  provides,  inter  alia,  that 
only  the  retiring  auditor  shall  be  eligible  for  appointment  for 
the  coming  year,  unless  notice  of  intention  to  make  another 
nomination  has  been  given  previous  to  the  annual  meeting,  a 
copy  of  such  notice  having  been  sent  to  the  retiring  auditor, 
and  all  the  stockholders  likewise  notified,  prior  to  the  date  of 
the  meeting.  This  course  of  procedure  protects  the  auditor 
as  the  proposal  to  change  auditors  would  naturally  cause  in- 
quiry to  be  made  as  to  the  reason  therefor,  thus  giving  the 
auditor  an  opportunity  to  acquaint  the  stockholders  with  the 
facts. 

Until  it  becomes  the  custom  in  the  United  States  for  stock- 
holders to  appoint  the  auditor  of  a  corporation,  the  auditor  will 
always  be  at  more  or  less  of  a  disadvantage  as  the  directors — 
in  the  case  of  a  disagreement  between  themselves  and  the 
auditor  or  in  the  event  of  the  auditor  criticising  any  of  their 
actions — can  simply  publish  the  accounts  without  the  auditor^s 
certificate  and  the  average  stockholder  be  none  the  wiser. 

"PRIVILEGE"  OF  AUDITORS.— Another  reform  in 
this  connection  which  is  earnestly  needed  is  absolute  "  privi- 
lege "  upon  the  part  of  an  auditor  in  his  reports.  To  a  certain 


284  AUDITING. 

extent  he,  no  doubt,  has  this  privilege  at  the  present  time ;  but 
the  point  is  not  free  from  doubt,  and  it  should  be  absolutely 
clear.  If  the  auditor  is  of  the  opinion  that  something  which 
has  been  done  by  the  directors,  or  by  any  outside  persons,  calls 
for  the  attention  of  the  stockholders,  he  should  be  in  such  a 
position  that  he  need  feel  no  hesitation  in  expressing  his  view. 
He  ought  also  to  have  a  clearly  defined  right  to  circularize  the 
stockholders,  if  need  be,  at  any  time ;  and  more  particularly, 
in  the  event  of  his  having  resigned,  as  to  the  reasons  for  his 
resignation.  It  will,  of  course,  be  said  that,  were  this  done,, 
many  sound  companies  and  many  honest  boards  of  directors 
would  be  placed  at  the  mercy  of  unscrupulous  auditors ;  but 
there  is  at  least  no  more  harm  in  a  company  being  at  the  mercy 
of  unscrupulous  auditors  than  its  being  at  the  mercy  of  un- 
scrupulous directors,  and  unquestionably  the  latter  are  more 
common  than  the  former.  Besides,  the  auditor  would  always 
be  liable  to  be  called  upon  to  justify  the  position  which  he 
had  taken  up;  and  nothing  could  protect  him  in  the  way  of 
"  privilege  "  if  it  could  be  shown  that  he  had  not  been  actuated 
by  motives  of  good  faith. 

REMOVAL  OF  AUDITORS.— Passing  on  to  the  ques- 
tion of  the  removal  of  an  auditor.  Under  the  English  Com- 
panies Act,  this  can  only  be  done  by  the  company  at  its  annual 
general  meeting — that  is  to  say,  the  only  practical  way  of  re- 
moving an  auditor  is  not  to  re-elect  him  when  his  year  of 
office  has  expired.  As,  however,  most  companies  only  require 
the  services  of  their  auditors  immediately  before  such  annual 
meeting,  this  for  all  practical  purposes  amounts  to  an  ap- 
pointment at  will ;  and,  in  view  of  the  fact  that,  under  any  but 
the  most  abnormal  circumstances,  the  directors  of  a  company 
can  always  secure  a  majority  at  a  poll,  it  will  be  seen  that  the 
auditor  practically  holds  his  appointment  from  the  directors, 
even  although  he  may  nominally  receive  his  appointment  from 
the  stockholders.  That  section  of  the  Companies  Act  of  1908 
to  which  reference  has  been  made   under  "  Resignation  of 


THE  auditor's  POSITION.  285 

Auditors  "  secures  to  a  certain  extent  the  auditor's  tenure  of 
office. 

Of  course,  under  the  present  practice  in  the  United  States 
(where  an  auditor  is  appointed  by  the  directors,  or  the  officers, 
for  a  specific  purpose)-  the  question  of  his  removal  rarely 
arises. 

DUTIES  OF  AUDITORS.— With  regard  to  the  question 
of  the  duties  of  an  auditor  while  in  office.  There  being,  up 
to  the  present  at  all  events,  no  very  definite  provisions  with 
regard  to  this  matter,  the  question  is  largely  one  of  contract 
between  each  individual  auditor  and  the  company.  The  basis 
of  that  contract  will  be  construed  by  the  courts  chiefly  from 
the  facts  of  each  individual  case. 

In  this  connection  it  may  be  pointed  out  in  passing  that, 
even  with  regard  to  such  important  questions  as  the  value  of 
assets,  provision  for  depreciation,  the  assessment  of  profits 
earned,  and  the  distribution  of  unrealized  profits,  the  courts 
have  shown  a  marvelous  disinclination  to  lay  down  any  gen- 
eral rules  which  could  be  regarded  as  principles  for  the  safe 
guidance  of  auditors  in  the  future.  In  carefully  and  labori- 
ously shirking  their  duties  in  this  respect,  however,  the  courts 
have  been  most  ably  seconded  by  the  legislatures,  which  have 
been  particularly  cautious  in  abstaining  from  laying  down  any 
exact  rules  as  to  what  the  duties  of  an  auditor  may  be.  No 
doubt  they  have  acted  wisely  in  adopting  this  course,  however, 
because  any  attempt  to  state  explicitly  what  the  duties  of 
auditors  are  in  all  cases  would  inevitably  fail  in  not  a  few, 
and  would  afford  the  best  possible  excuse  for  the  insufficiency 
of  the  audit  that  had  been  performed  in  such  cases.  Any 
legislative  act  which  attempts  to  classify  the  duties  of  an 
auditor  under  stereotyped  headings  must  at  least  profess  to 
be  at  the  same  time  exhaustive,  and  as  the  latter  is  impossible, 
it  seems  to  follow  that  the  former  is  very  inexpedient. 

RIGHTS  OF  AUDITORS.— The  rights  of  a  company 
auditor  may  be  very  shortly  dismissed.     He  has  but  few.     He 


286  AUDITING. 

has  the  right,  when  appointed  by  the  stockholders,  to  hold 
office  till  the  next  annual  meeting  of  the  company,  and  in  the 
absence  of  notice  prior  thereto  of  other  nominations  for  the 
office,  the  sole  right  to  appointment  for  the  coming  year.  He 
has  also  the  right  to  reasonable  remuneration,  or  at  such  a 
rate  as  the  company  is  general  meeting  may  be  pleased  to 
allow,  where  he  is  acting  under  a  specific  provision  to  that 
effect.  When  appointed  by  the  stockholders,  he  has  the  right 
to  examine  the  books  and  accounts  of  the  company  at  all  rea- 
sonable times  (which,  unless  coupled  with  a  reasonable  scale 
of  remuneration,  is,  perhaps,  rather  more  of  a  curse  than  a 
blessing). 

When  appointed  by  the  directors,  he  usually  has  the  right  to 
make  inquiries  from  any  of  the  officers  of  the  company. 

When  appointed  by  the  president  of  a  company,  who  is,  per- 
haps, the  officer  usually  charged  with  selecting  the  auditor,  he 
usually  has  the  right  to  make  inquiries  from  any  of  the  other 
officers,  and  sometimes  he  may  interrogate  the  president  him- 
self! 

When  appointed  by  the  treasurer,  who  is  also  frequently 
authorized  to  employ  the  auditor  of  his  own  accounts,  he  must 
simply  discharge  his  duties  and  accept  his  full  measure  of  re- 
sponsibility, even  though  he  cannot  help  seeing  that  a  certain 
kind  of  report  is  equivalent  to  notice  that  his  services  will  not 
6e  required  at  the  next  audit. 

In  this  connection  it  may  be  interesting  to  note  some  of  the 
provisions  with  respect  to  auditors  which  are  contained  in  the 
English  Companies  (ConsoHdation)  Act,  1908  (8  Edw.  7, 
Ch.  69). 

Section  112. — (i)  Every  company  shall  at  each  annual  general  meet- 
ing appoint  an  auditor  or  auditors  to  hold  office  until  the  next  annual 
general  meeting. 

(2)  If  an  appointment  of  auditors  is  not  made  at  an  annual  general 
meeting,  the  Board  of  Trade  may,  on  the  application  of  any  member 
of  the  company,  appoint  an  auditor  of  the  company  for  the  current 


THE  auditor's  POSITION.  287 

year,  and  fix  the  remuneration  to  be  paid  to  him  by  the  company  for 
his  services. 

(3)  A  director  or  officer  of  the  company  shall  not  be  capable  of 
being  appointed  auditor  of  the  company. 

(4)  A  person,  other  than  a  retiring  auditor,  shall  not  be  capable 
of  being  appointed  auditor  at  an  annual  general  meeting  unless  notice 
of  an  intention  to  nominate  that  person  to  the  office  of  auditor  has 
been  given  by  a  shareholder  to  the  company  not  less  than  fourteen 
days  before  the  annual  general  meeting,  and  the  company  shall  send 
a  copy  of  any  such  notice  to  the  retiring  auditor,  and  shall  give  notice 
thereof  to  the  shareholders,  either  by  advertisement  or  in  any  other 
mode  allowed  by  the  articles,  not  less  than  seven  days  before  the 
annual  general  meeting: 

Provided,  that  if,  after  notice  of  the  intention  to  nominate  an  audi- 
tor has  been  so  given,  an  annual  general  meeting  is  called  for  a  date 
fourteen  days  or  less  after  the  notice  has  been  given,  the  notice,  though 
not  given  within  the  time  required  by  this  provision,  shall  be  deemed 
to  have  been  properly  given  for  the  purposes  thereof,  and  the  notice 
to  be  sent  or  given  by  the  company  may,  instead  of  being  sent  or  given 
within  the  time  required  by  this  provision,  be  sent  or  given  at  the  same 
time  as  the  notice  of  the  annual  general  meeting. 

(5)  The  first  auditors  of  the  company  may  be  appointed  by  the 
directors  before  the  statutory  meeting,  and,  if  so  appointed,  shall  hold 
office  until  the  first  annual  general  meeting,  unless  previously  removed 
by  a  resolution  of  the  shareholders  in  general  meeting,  in  which  case 
the  shareholders  at  that  meeting  may  appoint  auditors. 

(6)  The  directors  may  fill  any  casual  vacancy  in  the  office  of 
auditor,  but  while  any  such  vacancy  continues  the  surviving  or  con- 
tinuing auditor  or  auditors,  if  any,  may  act. 

(7)  The  remuneration  of  the  auditors  of  a  company  shall  be  fixed 
by  the  company  in  general  meeting,  except  that  the  remuneration  of  any 
auditors  appointed  before  the  statutory  meeting,  or  to  fill  any  casual 
vacancy,  may  be  fixed  by  the  directors. 

Section  113. — (i)  Every  auditor  of  a  company  shall  have  a  right  of 
access  at  all  times  to  the  books  and  accounts  and  vouchers  of  the  com- 
pany, and  shall  be  entitled  to  require  from  the  directors  and  officers 
of  the  company  such  information  and  explanation  as  may  be  necessary 
for  the  performance  of  the  duties  of  the  auditors. 

(2)  The  auditors  shall  make  a  report  to  the  shareholders  on  the 
accounts  examined  by  them,  and  on  every  balance  sheet  laid  before 


288  AUDITING. 

the  company  in  general  meeting  during  their  tenure  of  office,  and  the 
report  shall  state — 

(a)  whether   or   not   they  have   obtained   all   the   information   and 

explanations  they  have  required;  and 

(b)  whether,  in  their  opinion,  the  balance  sheet  referred  to  in  the 

report  is  properly  drawn  up  so  as  to  exhibit  a  true  and 
correct  view  of  the  state  of  the  company's  affairs  according 
to  the  best  of  their  information  and  the  explanations  given 
to  them,  and  as  shown  by  the  books  of  the  company. 

(3)  The  balance  sheet  shall  be  signed  on  behalf  of  the  board  by  two 
of  the  directors  of  the  company,  or,  if  there  is  only  one  director,  by 
that  director,  and  the  auditors'  report  shall  be  attached  to  the  balance 
sheet,  or  there  shall  be  inserted  at  the  foot  of  the  balance  sheet  a  ref- 
erence to  the  report,  and  the  report  shall  be  read  before  the  company 
in  general  meeting,  and  shall  be  open  to  inspection  by  any  shareholder. 

Any  shareholder  shall  be  entitled  to  be  furnished  with  a  copy  of  the 
balance  sheet  and  auditors'  report  at  a  charge  not  exceeding  sixpence 
for  every  hundred  words. 

(4)  If  any  copy  of  a  balance  sheet  which  has  not  been  signed  as 
required  by  this  section  is  issued,  circulated,  or  published,  or  if  any 
copy  of  a  balance  sheet  is  issued,  circulated,  or  published  without  either 
having  a  copy  of  the  auditors'  report  attached  thereto  or  containing 
such  reference  to  that  report  as  is  required  by  this  section,  the  company, 
and  every  director,  manager,  secretary,  or  other  officer  of  the  company 
who  is  knowingly  a  party  to  the  default,  shall,  on  conviction,  be  liable 
to  a  fine  not  exceeding  fifty  pounds. 

(5)  In  the  case  of  a  banking  company  registered  after  the  fifteenth 
day  of  August,  eighteen  hundred  and  seventy-nine — 

(a)  if  the  company  has  branch  banks  beyond  the  limits  of  Europe, 

it  shall  be  sufficient  if  the  auditor  is  allowed  access  to  such 
copies  of  and  extracts  from  the  books  and  accounts  of  any 
such  branch  as  have  been  transmitted  to  the  head  office  of 
the  company  in  the  United  Kingdom ;  and 

(b)  the  balance  sheet  must  be  signed  by  the  secretary  or  manager 

(if  any),  and  where  there  are  more  than  three  directors  of 
the  company  by  at  least  three  of  those  directors,  and  where 
there  are  not  more  than  three  directors  by  all  the  directors. 

Section  114. — (i)  Holders  of  preference  shares  and  debentures  of  a 
company  shall  have  the  same  right  to  receive  and  inspect  the  balance 


THE  auditor's  POSITION.  289 

sheets  of  the  company  and  the  reports  of  the  auditors  and  other  reports 
as  is  possessed  by  the  holders  of  ordinary  shares  in  the  company. 

(2)     This  section  shall  not  apply  to  a  private  company,  nor  to  a  com- 
pany registered  before  the  first  day  of  July,  nineteen  hundred  and  eight. 


CHAPTER  X. 


THE  LIABILITIES  OF  AUDITORS. 


THE  LIABILITIES  OF  AUDITORS. 

Turning  now,  again,  to  the  general  aspect  of  the  question, 
it  will  be  well  to  consider  the  extent  of  the  auditor's  liability 
in  connection  with  accounts  that  he  has  certified. 

The  question  appears  to  be  capable  of  division  under  two 
heads,  viz.: — 

( 1 )  What  is  the  actual  extent  of  the  auditor's  certification  ? 

(2)  What  is  his  legal  responsibility  in  case  of  an  error 

being  subsequently  discovered  in  accounts  that  have 
been  passed  by  him? 

To  take  these  two  points  separately: 

THE  EXTENT  OF  AN   AUDITOR'S   CERTIFICATION. 

Unfortunately,  this  is  a  matter  upon  which  the  profession  is 
by  no  means  agreed ;  while,  on  the  other  hand,  the  cases  that 
have  been  decided  by  the  courts  are  so  few,  and  the  questions 
actually  at  issue  so  narrow,  that  sufficient  precedents  are  not 
even  yet  available  to  definitely  settle  the  matter.  At  the  same 
time,  it  is  well  to  remember  that,  however  desirable  it  may  be 
to  know  exactly  the  bare  extent  of  the  legal  responsibility,  the 
real  professional  responsibility  to  clients  ought  always  to  be 
the  ideal ;  and,  further,  an  auditor  will  be  the  worst  of  friends 
to  his  profession  if  he  studiously  exert  himself  to  narrow  the 
responsibilities,  and  so  to  dwarf  the  importance  of  his  position. 

290 


THE  EXTENT  OF  AN  AUDITOR'S  CERTIFICATION.  29I 

The  responsibility  involved  in  certifying  a  balance  sheet  to 
be  absolutely  correct  would  be  so  great,  so  limitless,  that 
many  have  preferred  to  discard  all  claim  to  such  a  position  of 
certainty,  and  prefer  merely  to  certify  a  balance  sheet  as  being 
"  in  accordance  with  the  books/'  Auditors,  however,  will 
hardly  require  to  be  reminded  that  an  investigation  which  had 
been  limited  to  the  comparison  of  a  balance  sheet  with  the 
books  would  be,  for  every  purpose,  absolutely  valueless.  So 
obvious  is  this  conclusion  that  no  professional  auditor  would 
ever  think  of  confining  his  investigation  to  this  particular 
point,  yet  many  experienced  auditors  appear  to  be  afraid  to 
make  any  certification  as  to  the  result  of  such  further  investi- 
gation as  they  know  to  be  essential.  Such  a  state  of  affairs 
is  unsatisfactory  to  the  client  and  discreditable  to  the  auditor. 
Again,  it  is  a  very  open  question  whether  so  unsatisfac- 
tory a  certificate  would  ever  have  the  effect  of  limiting  the 
legal  responsibility  of  the  auditor  to  the  exact  points  certified. 
It  is,  at  least,  possible  that  our  courts  would  view  the  matter 
from  a  broader  aspect,  and  consider  that  the  man  who  had 
accepted  the  position  of  auditor  to  say  nothing  of  the  fees 
incident  thereto — had  also  undertaken  the  responsibilities  of 
that  position — and  that  it  would  be  disposed  to  form  its  own 
opinion  as  to  the  real  extent  of  such  responsibilities.  Such, 
indeed,  appears  to  have  been  the  view  taken  in  an  English 
case  by  Justice  Stirling,  in  the  case  of  The  Leeds  Estate,  &€., 
Society.  (Pages  310,  358  hereof.)  It  would  appear,  therefore, 
that  the  auditor  who  does  not  consider  his  investigation  has 
been  sufficiently  searching  escapes  no  liability  by  issuing  a 
carefully  modified  certificate ;  and,  indeed,  such  a  course  is 
somewhat  dishonest.  These  are  strong  words,  but  not  stronger 
than  the  circumstances  appear  to  require. 

But  it  is  not  intended  to  convey  the  impression  that  an 
auditor  who  through  no  fault  of  his  own,  has  been  unable  to 
make  a  satisfactory  investigation,  and  who  makes  no  attempt 
to  conceal  the  actual  facts  in  his  certificate,  is  censurable.  He, 
of  course,  has  not  issued  a  "  carefully  modified  "  certificate. 


292  AUDITING. 

The  English  Companies  Act  of  1908  requires  the  auditors 
to  make  their  quahfications,  not  at  the  foot  of  the  pubHshed 
accounts,  but  in  a  report  which  the  directors  are  required  to 
have  read  at  the  general  meeting.  This  report  may — and, 
of  course,  should  be — as  lengthy  and  as  detailed  as  circum- 
stances may  require,  and  there  is  thus — now,  at  least — no 
excuse  for  cryptic  certificates  which  may  mean  anything  or 
nothing.  While  there  is  no  statutory  requirement  in  effect 
in  the  United  States  governing  the  form  of  auditor's  reports, 
it  is  suggested  that  the  auditor  should  so  word  them  as  to 
encourage  by  every  means  that  lies  in  his  power,  an  intelli- 
gent and  active  interest  on  the  part  of  stockholders  in  the 
accounts  of  the  company,  and  in  its  finances  generally. 

A  very  careful  search  of  the  Supreme  Court  Reports  of 
each  State  in  the  Union  fails  to  reveal  a  single  case  bearing 
on  the  liabilities  of  professional  auditors.  We  must,  there- 
fore, resort  to  the  English  decisions,  which  are  fairly  numer- 
ous. 

It  may  be  added  that  the  English  standard  is  by  no  means 
too  high,  and  may  be  accepted  as  a  proper  criterion  for  Ameri- 
can practitioners.  Furthermore,  it  is  altogether  likely  that 
until  a  line  of  American  decisions  has  been  established  the 
identical  cases  here  reported  will  be  used  as  precedents  for 
the  American  cases  which  may  arise. 

Many  years  ago  a  prominent  English  accountant  expressed 
himself  as  follows :  "  I  know  perfectly  well  that  a  proper 
auditor  must  go  further  (than  comparing  the  published  ac- 
counts with  the  books)  and  see  that  the  books  themselves 
do  correspond  with  facts,"  and  this  view  appears  to  be  endorsed 
by  the  legal  decisions  to  be  considered  later  on.  As  to  how  far 
it  is  possible  for  this  standard  to  be  carried  into  practice,  there 
is,  perhaps,  room  for  some  difference  of  individual  opinion,  but 
the  general  statement  is  absolutely  unassailable. 

In  actual  practice,  however,  the  question  naturally  arises: 
How  is  the  auditor  to  ascertain  the  actual  facts?     To  which 


THE  EXTENT  OF  AN  AUDITOR'S  CERTIFICATION.  293 

it  may  be  replied :  In  the  same  manner  as  a  judge  or  jury — 
by  sifting  evidence.  The  chief  evidence  is,  of  course,  the 
books  (and  it  may  be  remarked  incidentally,  that  it  is  clearly 
the  auditor's  duty  to  see  that  the  accounts  he  certifies,  in 
addition  to  being  correct,  are  in  accordance  with  the  books), 
but  the  books  must  not  be  considered  the  sole  source  of  evi- 
dence ;  the  fact  that  a  statement  appears  in  the  books  is  prima 
facie  evidence  only,  and  must  be  verified,  either  by  internal 
cross  examination,  or  by  reliable  and  independent  evidence, 
whether  documentary  (vouchers,  &c.)  or  oral  (explanations). 

The  result  of  such  an  investigation  will  be  that  the  auditor 
has  proved  to  himself  that  certain  statements  represent  abso- 
lutely indisputable  facts,  and  that  certain  other  statements,  in 
his  opinion,  appear  to  represent  facts.  Beyond  this — not  be- 
ing omniscient — he  cannot  go,  and  should  never  attempt  to 
go.  Let  him,  therefore,  report  that  he  has  thoroughly  exam- 
ined the  accounts,  that  they  are  in  accordance  with  the  books, 
and  are,  in  his  opinion,  correctly  stated ;  he  will  then  be  occupy- 
ing a  logical,  manly  position — far  more  in  keeping  with  the 
dignity  of  his  profession  than  that  afforded  by  the  most 
skilful  of  word- juggling. 

The  view  laid  down  in  the  two  preceding  paragraphs  is  that 
which  appeared  in  the  first  English  edition  of  this  work,  which 
was  published  in  1892,  before  the  London  and  General  Bank 
had  failed,  and  before  the  celebrated  case  in  connection  with 
that  failure  was  thought  of ;  but  nothing  that  has  since  occurred 
has  in  any  degree  tended  to  discredit  the  line  of  argument  then 
taken.  On  the  contrary,  the  judgment  of  Lord  (then  Lord 
Justice)  Lindley  fully  endorses  the  author's  view.  This  judg- 
ment, together  with  that  of  the  late  Lord  Justice  Rigby,  will  be 
found  fully  reported  in  Appendix  "A  " ;  but  for  the  sake  of 
clearness,  and  on  account  of  its  extreme  importance,  it  has 
been  thought  desirable  to  reproduce  here  the  following  extract 
from  Lord  Justice  Lindley's  judgment: — 

"  It  is  no  part  of  an  auditor's  duty  to  give  advice  either  to  directors 
or  shareholders  as  to  what  they  ought  to  do.     An  auditor  has  noth- 


294  AUDITING. 

ing  to  do  with  the  prudence  or  imprudence  of  making  loans  with  or 
without  security.  It  is  nothing  to  him  whether  the  business  of  a  com- 
pany is  being  conducted  prudently  or  imprudently,  profitably  or  un- 
profitably;  it  is  nothing  to  him  whether  dividends  are  properly  or  im- 
properly declared,  provided  he  discharges  his  own  duty  to  the  share- 
holders. His  business  is  to  ascertain  and  state  the  true  financial  posi- 
tion of  the  company  at  the  time  of  the  audit,  and  his  duty  is  confined 
to  that.  But  then  comes  the  question:  How  is  he  to  ascertain  such 
position?  The  answer  is:  By  examining  the  books  of  the  company. 
But  he  does  not  discharge  his  duty  by  doing  this  without  inquiry  and 
without  taking  any  trouble  to  see  that  the  books  of  the  company  them- 
selves show  the  company's  true  position.  He  must  take  reasonable 
care  to  ascertain  that  they  do.  Unless  he  does  this,  his  duty  will  be 
worse  than  a  farce.  Assuming  the  books  to  be  so  kept  as  to  show 
the  true  position  of  the  company,  the  auditor  has  to  frame*  a  balance 
sheet,  showing  that  position  according  to  the  books,  and  to  certify 
that  the  balance  sheet  presented  is  correct  in  that  sense.  But  his  first 
duty  is  to  examine  the  books,  not  merely  for  the  purpose  of  ascertain- 
ing what  they  do  show,  but  also  for  the  purpose  of  satisfying  him- 
self that  they  show  the  true  financial  position  of  the  company.  This 
is  quite  in  accordance  with  the  decision  of  Mr.  Justice  Stirling  in  The 
Leeds  Estate  Company  v.  Shephard,  in  z^  Chancery  Division,  page  802. 
An  auditor,  however,  is  not  bound  to  do  more  than  exercise  reason- 
able care  and  skill  in  making  inquiries  and  investigations.  He  is  not 
an  insurer;  he  does  not  guarantee  that  the  books  do  correctly  show 
the  true  position  of  the  company's  affairs;  he  does  not  guarantee  that 
his  balance  sheet  is  accurate  according  to  the  books  of  the  company. 
If  he  did  he  would  be  responsible  for  an  error  on  his  part,  even  if  he 
were  himself  deceived,  without  any  want  of  reasonable  care  on  his 
part — say,  by  the  fraudulent  concealment  of  a  book  from  him.  His 
obligation  is  not  so  onerous  as  this. 

"  Such  I  take  to  be  the  duty  of  the  auditor ;  he  must  he  honest — 
that  is,  he  must  not  certify  what  he  does  not  believe  to  be  true,  and  he 
must  take  reasonable  care  and  skill  before  he  believes  that  what  he 
certifies  is  true. 

"What  is  reasonable  care  in  any  particular  case  must  depend  upon 
the  circumstances  of  that  case.  Where  there  is  nothing  to  excite  sus- 
picion, very  little  inquiry  will  be  reasonable  and  sufficient ;  and  in  prac- 
tice, I  believe,  business  men  select  a  few  cases  at  haphazard,  see  that 
they  are  right,  and  assume  that  others  like  them   are  correct  also. 


*  This  is  clearly  a  lapsus  lingua;:  it  is  no  part  of  an  Auditor  s  duty  to  prepare 
accounts,  but  to  examine  and  report  upon  accounts  prepared  by,  or  on  behalf  of, 
the  directors. 


THE  EXTENT  OF  AN  AUDITOR^S  CERTIFICATION.  295 

Where  suspicion  is  aroused  more  care  is  obviously  necessary,  but  still 
an  auditor  is  not  bound  to  exercise  more  than  reasonable  care  and 
skill,  even  in  a  case  of  suspicion;  and  he  is  perfectly  justified  in  acting 
on  the  opinion  of  an  expert,  where  special  knowledge  is  required. 

"  Mr.  Theobald's  evidence  satisfies  me  that  he  took  the  same  view 
as  myself  of  his  duty  in  investigating  the  company's  books  and  pre- 
paring his  balance  sheet.  He  did  not  content  himself  with  making  his 
balance  sheet  from  the  books  without  troubling  himself  about  the 
truth  of  what  they  showed.  He  checked  the  cash,  examined  vouchers 
for  payments,  saw  that  the  bills  and  securities  entered  in  the  books 
were  correct,  took  reasonable  care  to  ascertain  their  value,  and  in  one 
case  obtained  a  solicitor's  opinion  on  the  validity  of  an  equitable 
charge.  I  see  no  trace  whatever  of  any  failure  by  him  in  the  per- 
formance of  this  part  of  his  duty.  It  is  satisfactory  to  find  that  the 
legal  standard  of  duty  is  not  too  high  for  business  purposes,  and  is 
recognized  as  correct  by  business  men.'* 

The  reasons  why  their  Lordships  felt  constrained  to  give 
judgment  against  the  defendant,  notwithstanding  the  fact  that 
they  could  "  see  no  trace  whatever  of  any  failure  by  him  in 
the  performance  of  this  part  of  his  duty,"  will  be  considered 
under  the  following  sub-heading. 

Since  the  second  English  edition  of  this  work  was  published 
several  important  decisions  with  regard  to  the  liability  of 
auditors  have  been  delivered  by  the  English  Courts,  which — 
to  a  certain  extent,  although  still  very  unsatisfactory — tend  to 
further  define  the  extent  of  an  auditors'  certification.  It  is 
thought  that  the  points  raised  in  these  various  judgments  can 
be  more  conveniently  dealt  with  under  the  heading  of  the 
liabilities  of  auditors.  It  may  be  mentioned  here,  however, 
that,  in  the  Kingston  Cotton  Mills  case,  it  was  decided  by  Mr. 
(now  Lord)  Justice  Vaughan  Williams  that  although  the  di- 
rectors of  a  company  were  justified  in  accepting  the  certificate 
of  the  managing  director  as  to  the  amount  of  stock  in  hand, 
the  auditors  were — at  all  events  in  that  particular  case — not 
so  justified,  and  that  although  their  certificate  was  qualified 
accordingly;  but  this  decision  was  overruled  by  the  Court  of 
Appeal. 


296  AUDITING. 

An  interesting  side-light  upon  the  exact  extent  of  an  audi- 
tor's certification  is  afforded  by  the  proceedings  of  the  Select 
Committee  of  the  House  of  Lords  appointed  in  1896  to  in- 
quire into  Company  Law  Amendment,  upon  the  occasion  of 
the  examination  of  Mr.  Frederick  Whinney,  F.C.A.  The 
following  extract  from  the  published  report  of  these  proceed- 
ings will  be  found  of  no  little  interest,  but  it  is  important  to 
remember  that,  although  some  of  the  Law  Lords  have  here 
expressed  themselves  in  terms  that  appear  to  be  widely  differ- 
ent from  those  which  have  from  time  to  time  been  used  by 
other  judges,  they  were  not  speaking  ex  cathedra;  and  further 
that,  although  the  distinct  suggestion  is  that,  should  a  case  be 
brought  before  it,  the  House  of  Lords  might  see  fit  to  overrule 
some  of  the  decisions  already  given  by  the  Court  of  Appeal, 
it  does  not  necessarily  follow  that  their  Lordships  would 
adhere  to  those  views  (as  expressed  below)  when  the  time 
came : — 

"  Passing  to  clause  29,  which  deals  with  the  appaintment  of  auditors^ 
he  suggested  the  addition  of  words  to  the  efifect  that,  unless  it  was 
otherwise  provided  by  the  articles  of  association,  one  of  the  auditors 
or  the  auditor,  if  there  was  only  one,  should  be  a  professional  account- 
ant, and  should  not  necessarily  be  a  shareholder.  In  support  of  that 
proposition,  he  pointed  out  that  joint-stock  enterprise  had  grown  very 
largely  of  late  years,  and  he  maintained  that  very  few  balance  sheets 
could  be  audited  properly  except  by  a  professional  accountant.  He 
went  on  to  suggest  the  insertion  in  the  bill  of  a  provision  that  no  audi- 
tor, other  than  the  retiring  auditor,  should  be  appointed  at  a  general 
meeting,  unless  notice  had  been  sent  out  to  the  shareholders  with  the 
notice  of  meeting.  That,  he  said,  was  brought  forward  with  the  ob- 
ject of  preventing  the  question  of  the  auditor  being  *  rushed,'  as  was 
sometimes  the  case  at  present.  The  bill  provided  that  there  should 
be  a  balance  sheet  containing  all  details — technically,  what  was  known 
as  the  trial  balance.  It  was  scarcely  necessary  to  provide  for  that  by 
legislation,  because  a  balance  sheet  could  not  be  made  out  unless  the 
details  were  given.  As  to  the  duties  of  auditors,  the  bill  proposed 
that  they  should  use  reasonable  diligence  with  the  view  of  ascertaining 
that  the  books  of  the  company  had  been  properly  kept,  and  recorded 
correctly  the  financial  and  trading  transactions  of  the  company.  The 
latter  part  of  the  section  he  did  not  object  to,  but  he  thought  the  words 
*  properly  kept '  should  be  omitted.    '  Properly  kept '  was  a  vague  term,. 


THE  EXTENT  OF  AN  AUDITOR  S  CERTIFICATION.  297 

and  the  section  would  be  quite  sufficient  to  meet  the  difficulty  without 
its  insertion.  It  would  be  the  duty  of  the  auditors  to  say  that  the 
books  had  not  been  properly  kept  if  that  was  the  case. 

"  The  bill  cast  upon  auditors  the  duty  of  checking  the  balance  sheet, 
including  the  amount  of  debts  due  to  the  company  after  making  a 
proper  deduction  for  debts  considered  to  be  bad  or  doubtful.  It  would 
be  impossible  for  the  auditors  to  do  that  in  the  case  of  large  com- 
panies, where  the  debtors  numbered,  say,  1,000.  In  the  case  of  banks, 
for  instance,  where  the  number  of  debtors  was  very  large,  it  was 
found  necessary  to  keep  an  aggregate  account  of  debtors,  showing  the 
total  amount  due  to  the  company  by  its  debtors.  The  auditors  would 
have  to  take  that  account,  and  schedules  would  be  prepared,  and,  if 
necessary,  would  be  tested  afterwards.  The  duty  should  not  be  thrown 
upon  auditors  of  checking  every  balance.  In  one  case  he  might  men- 
tion the  debtors  numbered  750,000.  (Laughter.)  It  should  be  suffi- 
cient if  they  gave  a  certificate  to  the  effect  that  they  had  used  all  rea- 
sonable care  and  diligence  in  ascertaining  that  the  balance  sheet  was 
true." 

Lord  Davey  :  "  I  should  like  to  ask  whether  you  conceive  it  to  be 
the  proper  duty  of  an  auditor  to  say  not  only  whether  the  books  are 
properly  kept,  but  to  go  into  questions  behind  the  books,  and  say 
whether  the  assets  are  properly  valued  ?" — "  I  do  not  know  that  I  can 
give  a  better  definition  of  the  duties  of  the  auditor  than  that  laid  down 
by  Lord  Justice  Lindley.  He  said  that  it  was  the  duty  of  an  auditor 
to  be  honest,  to  exercise  all  reasonable  care  and  skill  to  ascertain  that 
that  which  he  certifies  is  true,  and  to  exercise  all  reasonable  care  and 
skill  in  ascertaining  the  truth." 

Lord  Farrer  :  "  That  is  all  very  well ;  but  what  is  the  truth  which 
he  is  to  ascertain?"  Lord  Davey:  "Yes;  that  is  it.  Can  he,  for  in- 
tance,  when  the  properties  are  valued  at  a  certain  sum  in  the  books, 
and  on  the  face  of  the  books  are  properly  valued,  can  it  be  his  duty, 
not  being  a  valuer,  to  go  into  the  question  of  value  and  say  that  the 
directors  have  put  too  high  a  value  on  the  real  estate  ?  " — "  No ;  I  do 
not  think  so.  It  would  be  giving  the  auditor  a  different  position  from 
that  which  it  was  contemplated  he  should  have — namely,  that  he  should 
examine  the  accounts  of  the  directors  and  see  whether  they  are  correct. 
Anything  calculated  to  arouse  his  suspicion  he  ought,  of  course,  to 
look  into." 

Lord  Farrer  :  "  After  all,  the  responsibility  lies  with  the  directors  ?  " 
— "  Not  altogether  with  the  directors.  There  are  the  managers  of  the 
company." 


298  AUDITING. 

Lord  Farrer  :    "  Do  you  wish  to  place  the  auditor  in  the  position  of 
an  administrator,  who  is  to  check  the  directors  in  their  management 


Lord  Davey  :  "  Is  not  the  sounder  principle  this — ^that  the  auditor 
is  bound  to  know  everything  the  books  tell  him,  to  have  all  the  sus- 
picions that  the  books  suggest,  and  to  make  all  the  inferences  to  what 
he  finds  in  the  books  would  lead  him  ?  " — "  I  think  that  would  cover 
the  whole  of  his  duty.  I  think  it  is  his  duty  not  to  certify  a  balance 
sheet  until  he  believes  it  to  be  true,  and  he  has  taken  all  reasonable 
care  that  it  is  so.  He  is  bound  to  see  that  the  balance  sheet  is  brought 
before  the  shareholders  in  such  a  form  that  they  themselves  can  ex- 
ercise their  judgment  upon  it." 

"The  next  suggestion  he  had  to  make  was  that  the  pains  and  pen- 
alties of  auditors  should  be  modified.  At  present  the  auditor  was 
supposed  to  be  responsible  if  dividends  were  paid  out  of  capital."— 
Lord  Davey  :  "  Is  he  ?  I  never  knew  it  " —  The  Lord  Chancellor  : 
"  Putting  aside  fraudulent  connivance,  what  do  you  suppose  to  be  the 
responsibility  of  an  auditor?" — The  witness:  "That  if  dividends  have 
been  paid  out  of  capital,  assuming,  of  course,  that  the  company  is 
wound  up,  the  directors  and  auditors  are  responsible  for  the  amount 
of  the  dividends  so  paid,  subject  to  the  Statute  of  Limitations  in  favor 
of  the  auditors." — Lord  Davey  :  "  Where  do  you  find  that  ?  " — The 
Lord  Chancellor  :  "  I  am  not  aware  of  any  such  law.  I  am  not 
aware  of  any  case  in  which  the  innocent  mistake  of  a  director  has 
been  held  to  be  the  subject  for  an  action." — The  witness:  "There  was 
a  case  before  Mr.  Justice  Stirling." — Lord  Davey  :  "  There,  there  was 
fraudulent  connivance." — The  witness :  "  I  think  there  was  not  con- 
nivance, but  that  the  auditor  himself  was  ignorant." — The  Lord  Chan- 
cellor :  "  To  me  it  is  a  startling  suggestion  that  for  an  innocent  mis- 
take an  auditor  should  be  liable." 

The  view  expressed  by  Lord  Davey  above  was,  it  will  be 
seen,  that  the  auditor  is  bound  to  know  everything  the  books 
tell  him,  to  have  all  the  suspicions  the  books  suggest,  and  to 
make  all  the  inferences  to  which  all  that  he  finds  in  the  books 
would  lead  him.  This,  taken  by  itself,  is  a  somewhat  nar- 
rower view  than  had  been  previously  suggested  in  the  course 
of  this  chapter — namely,  that  the  books  must  not  be  considered 
as  the  sole  source  of  evidence — ^but  it  is  thought  there  is  very 
much  less  difference  between  these  views  than  is  at  first  appar- 
ent, and  that  Lord  Davey's  view  that  the  auditor  should  "  have 


auditor's  liability  for  defalcations.  299 

all  the  suspicions  which  a  careful  examination  of  the  books 
would  give  him  "  amounts  to  very  much  the  same  thing  as  the 
opinion,  already  expressed  in  these  pages,  that  the  books  them- 
selves are  prima  facie  evidence  only,  and  must,  in  all  cases  of 
•doubt,  be  verified  by  independent  inquiry. 

AUDITOR'S     LIABILITY     FOR     DEFALCATIONS     OF 
EMPLOYEES. 

The  question  as  to  whether — and  if  so,  to  what  extent — 
an  auditor  is  liable  to  his  clients  for  defalcations  committed 
by  their  employees,  is  one  of  very  considerable  importance, 
but,  unfortunately,  the  English  precedents  upon  the  subject 
are  not  sufficient  to  satisfactorily  establish  any  general  rule, 
and  so  far  not  a  single  American  precedent  can  be  found. 
The  reports  in  Wilde  v.  Cape  &  Dalgleish  and  Martin  v.  Isitt 
(both  of  which  will  be  found  in  Appendix  "A")  may  ad- 
vantageously be  consulted  in  this  connection;  but  it  cannot  be 
pretended  that  there  is  any  degree  of  finality  about  them. 
Pending  further  decisions,  however,  it  may,  perhaps,  not  un- 
reasonably be  assumed  that,  in  this  (as  in  other)  respects,  the 
auditor  will  be  liable,  in  most  of  our  States  at  least,  to  be 
proceeded  against  by  way  of  action  for  negligence  in  the  dis- 
charge of  his  duties ;  and,  if  it  could  be  shown  that  the  defal- 
cations had  resulted  from  the  negligence  or  incapacity  of  the 
auditor,  the  probability  is  that  he  would  be  held  liable  in  dam- 
ages accordingly.  The  most  interesting  of  the  two  cases  in 
question  is  undoubtedly  that  of  Martin  v.  Isitt,  in  which  the 
plaintiffs  claimed  damages  by  reason  of  the  fact  that  the 
monthly  audit,  which  the  defendants  had  contracted  to  per- 
form, had  been  allowed  to  fall  into  arrear,  and  that  the  defal- 
cations had  remained  undetected  for  a  longer  period  than, 
in  their  view,  was  reasonable.  The  case  was  eventually  set- 
tled without  any  definite  expression  of  opinion  upon  the  part 
of  the  judge  as  to  its  merits;  but  doubtless,  in  so  far  as  the 
delay  in  the  monthly  audit  was  unreasonable,  the  auditor  would 
be  responsible  for  any  loss  incurred  by  his  clients  in  conse- 


300  AUDITING. 

quence.  The  question  is  obviously,  therefore,  one  of  the  verjr 
greatest  importance  to  American  practitioners,  as  showing 
the  extreme  desirabiHty  of  monthly  and  other  periodical  audits 
being  punctually  proceeded  with,  and  the  case  cited  might 
profitably  be  re-read  at  intervals,  particularly  by  auditors  who 
make  a  specialty  of  periodical  audits.  On  the  other  hand,  a 
reasonable  margin  would,  no  doubt,  in  all  cases  be  allowed. 
It  would  be  manifestly  impossible  for  an  auditor  to  commence 
his  investigations  in  all  cases  immediately  after  the  period 
had  elapsed,  and  consequently  it  is  only  reasonable  to  suppose 
that  some  elasticity  would  be  used  in  applying  the  general  rule ; 
otherwise  the  position  of  professional  auditors,  say,  in  the 
month  of  January,  would  be  a  serious  one. 

With  regard  to  the  later  decision  upon  the  liabiHty  of  audi- 
tors in  the  event  of  defalcations  on  the  part  of  employees 
given  by  the  Irish  Court  of  Appeal  in  the  case  of  the  Irish 
Woollen  Co.,  Lim.  (a  report  of  which  appears  in  Appendix 
A),  it  is  important  to  bear  in  mind  that  the  decisions  of  this 
court  are  not  legal  precedents  in  England,  and  would  have 
little  weight  with  our  own  courts ;  but,  be  that  as  it  may,  it  is 
thought  that  the  proposition  previously  advanced  can  now  be 
entertained  with  even  less  doubt  than  before — namely,  that 
where  loss  is  incurred  through  the  defalcations  of  employees, 
which  defalcations  might  have  been  discovered  or  prevented 
by  the  exercise  of  due  diligence  the  auditor  will  be  liable.  It 
may  also  be  mentioned  that  in  this  case  stress  was  laid  on 
the  agreement  between  the  auditor  and  the  company  that  there 
should  be  a  "  monthly  "  audit,  although  there  appears  to  have 
been  some  conflict  as  to  what  was  actually  intended  by  this 
arrangement.     The  circumstances  were  as  follows: 

Dividends  had  been  paid  out  of  capital  on  the  faith  of  ac- 
counts which  were  afterwards  discovered  to  have  been  falsi- 
fied, and  the  charge  against  the  auditor  may  (in  eflfect)  be 
divided  into  three  headings : — 

(i)  That  he  failed  to  discover  that  the  stock  had  been  over- 
valued. 


AUDITOR^S  LIABILITY   FOR  DEFALCATIONS.  3OI 

(2)  That  he  failed  to  discover  that  the  book  debts  had  been 

overvalued 

(3)  That  he  failed  to  discover  that  the  trade  liabilities  had 

been  understated. 

With  regard  to  (i),  the  case  would  appear  to  be  upon  all- 
fours  with  the  decision  in  the  Kingston  Cotton  Mills  case,  and 
for  much  the  same  reasons  the  decision  of  the  court  was  in 
favor  of  the  auditor. 

(2)  Here,  again,  the  court  decided  in  the  auditor's  favor, 
on  the  ground  apparently  that  he  could  not  be  held  responsible 
for  the  insufficiency  of  the  reserve  provided  against  bad  debts, 
nor  for  the  omission  to  provide  for  cash  discounts.  With 
regard  to  bad  debts,  it  is  quite  clear  that  all  an  auditor  can  do 
is  to  make  reasonable  inquiries  as  to  the  sufficiency  of  the 
provision  made,  and  the  final  responsibility  must  in  all  fair- 
ness rest  with  the  directors  and  managers ;  but  it  would  appear 
to  be  the  duty  of  an  auditor  to  form  a  reasonable  opinion  as  to 
the  sufficiency  of  the  reserve,  and  to  qualify  his  report  if  in  his 
opinion  such  reserve  is  inadequate.  Upon  the  subject  of  cash 
discounts  it  would  not  have  been  surprising  if  the  court  had 
held  that  a  proper  provision  ought  to  have  been  made  for  the 
amount  which  it  was  expected  would  eventually  be  deducted 
on  payment  of  the  various  accounts,  although,  of  course,  per 
contra  cash  discounts  might  properly  be  deducted  from  the 
trade  liabilities.  In  this  respect  the  decision  of  the  Court  of 
Appeal  is,  perhaps,  more  favorable  to  the  auditor  than  might 
have  been  expected. 

(3)  It  was  in  respect  of  his  failure  to  discover  that  the 
trade  liabilities  were  understated  that  the  auditor  was  held 
liable  for  negligence.  There  would  seem  to  have  been  a  sys- 
tematic falsification  of  the  books  in  this  respect,  and  had  this 
falsification  been  discovered  at  an  earlier  stage,  it  would  have 
been  clear  that  the  dividends  paid  had  not  been  earned.  In- 
cidentally, the  discovery  of  falsification  in  the  books  under  this 
heading  would  naturally  have   aroused   suspicion   as   to  the 


302  AUDITING. 

accuracy  of  the  records  under  headings  (i)  and  (2).  With- 
out having  the  actual  books  before  one  it  is  difficult — if  not 
impossible  to  express  any  opinion  as  to  whether  or  not  a 
reasonably  careful  and  skilful  auditor  could  have  discovered 
the  frauds;  but  the  report  of  the  case  distinctly  suggests  that 
there  were  points  which  would  call  for  careful  inquiry,  and 
upon  which  in  point  of  fact  inquiry  was  actually  made  by  the 
auditor.  He  would  appear  to  have  noticed  that  certain  in- 
voices were  not  entered  in  the  books  until  after  the  period 
to  which  prima  facie  they  related,  and  to  have  inquired  as  to 
why  this  course  was  pursued.  The  explanation  given,  appar- 
ently, was  that  the  goods  relating  to  these  invoices  had  not 
been  included  in  stock.  The  explanation  is  by  no  means  un- 
reasonable, as  such  a  practice  is  certainly  not  contrary  to  the 
custom  of  many  perfectly  honest  undertakings.  In  the  King- 
son  Cotton  Mills  case  it  was  stated  that  "  auditors  must  not  be 
made  liable  for  not  tracking  out  ingenious  and  carefully-laid 
schemes  of  fraud  when  there  is  nothing  to  arouse  their  sus- 
picion, and  when  these  frauds  are  perpetrated  by  tried  ser- 
vants of  the  company,  and  are  undetected  for  years  by  the 
directors."  It  may  be  thought  that  these  remarks  would 
apply  equally  well  to  the  Irish  Woollen  Company  case ;  but  it 
may  be  pointed  out  that  the  practice  of  "  holding  back  "  in- 
voices because  goods  have  not  been  taken  into  stock,  although 
perhaps  in  itself  permissible,  is  one  which — considerations  of 
fraud  apart — ^might  easily  lead  to  mistakes.  So  that,  if  any 
means  are  available  for  checking  the  recprds  of  the  transac- 
tions, such  means  ought  not  to  be  neglected  by  a  reasonably 
careful  auditor.  It  appears  that  the  suppression  of  invoices 
would  have  been  at  once  discovered,  had  the  auditor  taken 
the  precaution  of  comparing  the  purchase  ledger  balances  with 
the  statements  of  account  forwarded  by  the  various  creditors ;. 
and,  that  being  so,  it  seems  reasonable  to  have  held  that  he 
was  guilty  of  negligence  in  omitting  to  take  this  precaution. 
Taken  by  itself,  however,  this  would  hardly  afford  grounds 
for  a  suit  for  damages.     It  is  true  that  the  "  stock-taking  " 


AUDITOR  S  LIABILITY  FOR  DEFALCATIONS.  303 

statements  would  only  have  disclosed  "  suppressed  '*  invoices, 
and  would  not  have  thrown  any  light  upon  the  invoices  "  car- 
ried over  " ;  but  the  discovery  of  a  large  number  of  invoices 
altogether  suppressed  would  at  once  arouse  suspicion  in  the 
mind  of  any  careful  auditor,  and  throw  upon  him  the  onus  of 
further  and  more  exhaustive  inquiry.  In  the  "  soft  goods  " 
trade  it  is  customary  in  England  for  creditors  to  be  asked 
to  send  in  "  stock-taking "  statements  to  be  compared  with 
the  purchase  ledger  balances,  so  that  particularly  in  the  case 
of  a  concern  carrying  on  such  a  business  as  that  of  the  Irish 
Woollen  Company,  Lim.,  does  it  seem  reasonable  that  the 
auditor  should  have  been  expected  to  take  this  precaution? 

The  most  recent  decision  in  conection  with  the  liability  of 
an  auditor  for  failure  to  detect  defalcations  is  that  in  the  case 
of  the  London  Oil  Storage  Company,  Lim.,  v.  Seear,  Hasluck 
&  Co.  (  vide  Appendix  "A"),  which  came  before  the  Lord 
Chief  Justice  and  a  special  jury  in  June,  1904.  To  the  casual 
onlooker  this  case  would  appear  to  be  quite  straightforward, 
but  Lord  Alverstone  devoted  so  much  care  to  his  summing 
up  that  it  seems  clear  the  matter  struck  him  as  being  one  of 
more  importance  and  more  difficulty  than  to  the  ordinary  ob- 
server to  be  the  case.  The  principles  governing  the  matter 
were,  he  said,  clear,  but  the  practical  application  of  those  prin- 
ciples to  any  individual  case  a  matter  of  the  very  greatest 
difficulty.  This  admission  is  to  be  welcomed,  as  affording  a 
most  acceptable  contrast  to  the  manner  in  which  the  courts 
regarded  the  views  of  auditors  a  dozen  years  ago;  but  if  the 
situation  in  the  case  referred  to  is  so  difficult  as  to  seriously 
tax  the  intelligence  of  a  special  jury,  it  is  clear  that  the  author 
was  by  no  means  overstating  the  case  when — in  the  fourth 
English  edition  of  this  work — he  expressed  the  view  that  such 
important  and  such  highly  technical  matters  ought  not,  in 
fairness  to  auditors,  ever  to  be  decided  by  a  single  judge. 
Briefly  stated,  the  points  at  issue  here  were  as  follows :  Dur- 
ing a  number  of  years  the  defendants  had  never  taken  any 
steps  to  verify  the  amount  of  cash  in  hand  appearing  on  the 


304  AUDITING. 

balance  sheet.  During  those  years  the  amount  of  this  bal- 
ance had  very  materially  increased,  and  during  the  latter  part 
of  the  period  had  not  been  shown  separately  from  the  balance 
at  bank.  Eventually,  owing  to  the  illness  of  the  responsible 
cashier,  it  was  discovered  that  the  bulk  of  this  balance  was 
non-existent,  with  the  result  that  the  company  sustained  a  loss 
of  some  hundreds  of  pounds.  On  behalf  of  the  defence  it  was 
argued  (i)  that  in  the  absence  of  suspicious  circumstances  an 
auditor  was  entitled  to  rely  upon  the  statements  of  trusted 
employees  (vide  Kingston  Cotton  Mills  case)  ;  (2)  that  there 
were  no  suspicious  circumstances  here;  (3)  that  the  directors 
had  not  had  their  suspicions  aroused,  and,  therefore,  if  the 
case  was  one  for  suspicion,  they  were  at  least  equally  negHgent ; 
(4)  that  there  was  no  evidence  to  show  that  the  whole  of  the 
deficiency  in  the  cash  balance  did  not  occur  since  the  date  of 
the  last  audit,  in  which  case  clearly  the  auditor  could  not  be 
responsible.  The  jury  found  that  during  the  last  four  years 
the  auditor  had  committed  a  breach  of  his  duty,  and  they 
assessed  the  damage  sustained  owing  to  this  breach  of  duty  at 
five  guineas,  adding  as  a  rider  that  they  considered  the  direc- 
tors had  been  guilty  of  gross  negligence.  Upon  the  whole, 
this  verdict  seems  to  be  a  very  fair  one,  and  certainly  it  can- 
not be  said  to  err  upon  the  side  of  severity.  It  is  thought, 
however,  that  the  defendants  made  their  case  worse  by  adopt- 
ing too  low  a  view  of  auditorial  responsibility.  There  are,  of 
course,  many  things  that  an  auditor  must  from  time  to  time 
take  upon  trust;  but  under  normal  circumstances  the  balance 
of  cash  in  hand  seems  to  be  the  one  asset  in  a  balance  sheet 
that  is  really  capable  of  absolute  and  unconditional  verifica- 
tion. In  the  absence,  therefore,  of  very  exceptional  circum- 
stances— as,  for  example,  in  the  case  of  an  undertaking  having 
numerous  branches — the  cash  in  hand  should  invariably  be 
verified  by  the  auditor.  The  actual  enumeration  of  the  balance 
of  cash  in  hand  at  each  branch  may  not  be  practicable,  but  so 
far  as  can  be  gathered  no  such  difficulty  arose  here;  while 
again  the  very  considerable  increase  of  cash  in  hand  (an  in- 
crease in  no  way  connected  with  the  actual  requirements  of  the 


LIABILITY  OF  AUDITORS  FOR  LIBEL.  305 

business)  ought,  it  is  thought,  to  be  in  all  cases  regarded  by 
the  careful  auditor  as  a  matter  calling  for  careful  inquiry,  if 
not  actually  a  matter  for  suspicion.  That  the  directors 
showed  gross  negligence  in  allowing  such  a  large  balance  to 
accumulate  in  the  hands  of  one  of  the  employees  of  the  com- 
pany goes,  of  course,  without  saying ;  but  it  would  be  straining 
the  decision  of  the  Court  of  Appeal  in  the  Kingston  Cotton 
Mills  case  too  far  to  suggest  that,  however  negligent  the  direc- 
tors of  a  company  may  be,  so  long  as  they  are  satisfied  the 
auditor  need  inquire  no  further.  Did  that  really  represent  the 
true  limit  of  an  auditor's  duties,  those  duties  might  be  re- 
garded as  adequately  discharged  if  the  auditor  did  nothing 
more  than  require  the  directors  to  sign  the  draft  balance  sheet 
before  he  did  so  himself !  It  is  obviously  in  the  interests  of 
professional  auditors  that  their  duties  should  not  be  made 
unduly  onerous,  and  that  they  should  not  be  held  responsible 
for  the  absolute  accuracy  of  statements  contained  in  the  ac- 
counts which  in  the  nature  of  things  it  is  impossible  for  them 
to  completely  verify ;  but  it  is  thought  that  it  is  equally  in  the 
interests  of  the  profession  that,  within  such  limits  as  may  be 
practicable,  the  full  responsibility  of  auditors  for  the  perform- 
ance of  their  duties  with  reasonable  care  and  reasonable  skill 
should  be  rigidly  enforced. 

LIABILITY  OF  AUDITORS  FOR  LIBEL. 

The  question  of  the  liability  of  an  auditor  for  libel  or  slan- 
der is  one  which  so  far  as  is  known  has  never  yet  been  seri- 
ously raised  in  America  or  elsewhere,  but  it  would  seem  that 
the  ordinary  rules  of  law  would  apply  hereto.  That  is  to  say, 
that,  when  the  alleged  libel  or  slander  is  true  in  point  of  fact, 
and  is  published  by  the  auditor  in  good  faith  and  without 
malice,  and  in  the  bona  Me  discharge  of  his  duty,  it  would,  no 
doubt,  be  held  to  be  privileged.  So  far,  the  proposition  is  emi- 
nently satisfactory ;  but  there  still  remains  for  consideration  the 
position  of  the  auditor,  assuming  that  he  were  mistaken  in  his 
facts,  or  assuming  that  he  had — in  all  good  faith — gone  some- 


306  AUDITING. 

what  outside  the  actual  scope  of  his  duty  in  the  particular 
matter.  In  these  cases  it  is  thought  that  the  question  would 
be  primarily  one  for  a  jury  to  decide,  but  that  every  reason- 
able indulgence  would  be  allowed  to  the  auditor  who  had 
acted  in  good  faith  and  without  malice.  Against  this,  how- 
ever, it  may  be  mentioned  that  in  the  unreported  action  of 
Weiner  v.  Wurtemhurg  Electro  Plate  Company  and  another, 
which  was  decided  in  England  in  1895,  the  plaintiff  claimed 
damages  against  the  defendants  for  libel,  on  the  ground  that 
the  defendant  company  had  instructed  and  authorized  the  co- 
defendants  (a  firm  of  Chartered  Accountants)  to  issue  a  cir- 
cular to  their  customers,  stating,  inter  alia,  that  the  plaintiff 
was  no  longer  in  their  employ,  and  that  "  the  bookkeeper  had 
already  been  arrested  on  a  charge  of  felony."  Mr.  Justice 
Hawkins  (now  Lord  Brampton,  P.  C.)  summed  up  very 
strongly  in  favor  of  the  defendants,  but  the  jury  found  a  ver- 
dict for  the  plaintiff  with  ±50  damages.  The  question  as  to 
whether  or  not  an  auditor  would  be  held  liable  in  any  particu- 
lar case  is  thus  really  more  dependent  upon  the  vagaries  of  the 
jury  concerned  than  upon  any  settled  question  of  law,  and  the 
position  is,  therefore,  a  highly  unsatisfactory  one. 

It  may  be  added  in  this  connection  that  in  England  it  is  set- 
tled law  that,  when  it  is  part  of  the  duty  of  any  persons  to 
attend  a  meeting  and  to  address  it,  any  statements  there  made 
by  them  in  good  faith  are  privileged.  Whatever  an  auditor 
may  state  in  his  report  to  the  stockholders,  under  Section  19 
of  the  English  Companies  Act,  1908,  is  therefore  clearly  privi- 
leged. As  to  how  far  this  would  apply  to  verbal  statements 
made  by  an  auditor  at  the  general  meeting  of  a  company 
may,  however,  be  reasonably  doubted,  inasmuch  as  it  is  by  no 
means  clear  that  an  auditor  has  any  statutory  right  under  their 
Companies  Act  to  attend  general  meetings.  Indeed,  it  has 
been  held  by  a  county  court  judge  that  he  has  no  such  right ; 
and,  although  this  is  a  view  from  which  probably  some  may 
differ,  the  point  is  by  no  means  altogether  free  from  doubt. 
It  has  certainly  never  been  settled  in  the  affirmative. 


CRIMINAL  LIABILITY  OF  AUDITORS.  3O7 

American  laws  relating  to  libel  and  slander  vary  with  the 
different  States,  and  can  hardly  be  said  to  be  in  harmony; 
it  is,  therefore,  not  feasible  to  discuss  them  within  the  limits 
of  this  volume.  It  is  suggested,  however,  that  it  would  be 
only  prudent  for  professional  auditors  to  acquaint  themselves 
with  the  statutes  of  their  own  States  bearing  on  these  subjects. 

THE     RESPONSIBILITY     OF    THE     AUDITOR     FOR 

ERRORS. 

Having  now  discussed  the  practical  extent  of  the  auditor's 
certification,  it  is  time  to  pass  on  to  a  consideration  of  his  lia- 
bilities, in  the  event  of  his  investigation  having  failed  to  detect 
and  expose  errors  or  frauds. 

CRIMINAL  LIABILITY  OF  AUDITORS. 

This  is  a  question  which  need  not  long  detain  us,  inas- 
much as  the  reported  cases  are  few  and  far  between.  In  the 
Portsea  Island  Building  Society  case,  criminal  proceedings 
were  instituted  against  the  directors  and  the  secretary  of  the 
society,  but  not  against  the  auditors.  The  directors  were, 
however,  acquitted,  and  the  case  is  only  of  interest  in  this 
connection,  inasmuch  as  Mr.  Justice  Hawkins  very  clearly 
stated,  in  the  course  of  his  summing  up,  that  the  evidence  be- 
fore him  had  established  a  civil  liability  upon  the  part  of  the 
auditor. 

In  the  case  of  the  Lancaster  Building  Society,  the  auditor, 
among  others,  was  charged  with  various  criminal  offences, 
but  was  acquitted ;  and  the  judge  in  his  summing-up  stated  to 
the  jury  that,  no  matter  how  scandalous  the  negligence  of 
an  auditor  might  be,  they  would  not  be  justified  in  returning 
a  verdict  of  guilty  unless  they  were  satisfied  that  there  was 
evidence  of  "  not  only  criminal  negligence,  but  also  of  fraudu- 
lent intent."* 


*  This,  of  course,  was  before  the  English  Companies  Act  1900  was  passed. 


308  AUDITING. 

The  auditors  of  the  two  Newfoundland  Banks  which  failed 
in  1894  were  also  tried,  in  conjunction  with  the  directors  of 
their  respective  companies,  and  likewise  acquitted. 

Since  the  fourth  English  edition  of  this  work  was  published, 
an  important  decision  has  been  given  that  supplements,  al- 
though it  does  not  modify,  the  views  already  expressed.  At 
the  trial  of  the  auditors  and  certain  other  officials  of  Dum- 
belVs  Banking  Company,  Lim.,  which  was  held  at  Douglas, 
Isle  of  Man,  in  November,  1900 — the  prosecution  took  place 
under  the  Manx  Criminal  Code  of  1872,  but  the  wording  of 
this  section  is  identical  with  that  of  the  English  Act  of  1862 
(24  &  25  Vict.,  c.  96,  section  84),  so  that  the  precise  locality 
of  the  prosecution  introduced  no  distinctive  element — ^the  de- 
fendants were  convicted  of  having  joined  in  the  issue  of  false 
balance  sheets,  knowing  them  to  be  false,  and  with  the  inten- 
tion to  deceive,  and  were  accordingly  sentenced  to  varying 
terms  of  imprisonment. 

If  it  were  necessary  to  deal  at  length  with  the  merits  of 
this  particular  case,  much  space  might  be  devoted  to  a  dis- 
cussion of  the  evidence,  with  a  view  to  seeing  whether  the 
charges  put  forward  were  actually  proved  up  to  the  hilt  in  all 
cases;  but  for  the  purposes  of  a  general  work  of  reference 
this  is  not  required.  It  may  be  pointed  out,  however,  that 
under  Section  28  of  the  English  Companies  Act  1900  any 
person  who  ''  wilfully  makes  a  statement  false  in  any  material 
particular "  in  "  any  return,  report,  certificate,  balance  sheet, 
or  other  document,  required  by  or  for  the  purposes  of  "  that 
Act,  "  knowing  it  to  be  false/'  is  guilty  of  a  misdemeanor, 
and  liable  on  conviction  to  fine  or  imprisonment.  This  sec- 
tion goes  somewhat  further  than  the  Act  of  1862,  inasmuch 
as  it  is  no  longer  necessary  to  prove  intent  to  deceive  or  de- 
fraud; but  it  is  thought  that  the  distinction  is  more  apparent 
than  real,  seeing  that  anyone  who  wilfully  makes  a  false  state- 
ment, "  knowing  it  to  be  false,''  would  invariably  be  assumed 
by  an  average  jury  to  have  made  it  for  some  purpose,  and  it 
is  unlikely  in  the  extreme  that  the  purpose  would  be  an  in- 


CIVIL  LIABILITY  OF  AUDITORS.  3O9 

nocent  one.  Practically,  therefore,  the  law  probably  stands 
exactly  where  it  did  before  the  passing  of  the  1900  Act,  save 
that  possibly  the  trial  of  any  person  charged  thereunder  might 
now  be  somewhat  shortened. 

Another  recent  criminal  case  which  is  of  interest  in'  this 
connection,  although  the  auditors  were  in  no  way  involved, 
is  the  trial  of  the  Managing  Director  and  Breweries  Manager 
of  Showcirs  Brezvery,  Lim.,  in  March,  1904,  on  various 
charges  of  fraud.  The  defendants,  who  were  convicted  and 
sentenced  respectively  to  fifteen  months'  and  nine  months'  im- 
prisonment, had  for  many  years  systematically  overvalued  the 
stock-in-trade,  and  had  induced  subordinate  employees  of  the 
company  to  certify  to  these  valuations  on  the  representation 
that  they  were  more  than  covered  by  existing  secret  reserves. 
The  case  is,  it  is  thought,  chiefly  of  interest  to  auditors,  in  that 
it  draws  attention  to  a  possible  very  serious  abuse  of  secret 
reserves,  and  emphasizes  the  importance  of  an  auditor  very 
carefully  inquiring  into  the  circumstances  under  which  re- 
course is  had  to  such  reserves  during  "  lean  "  years  to  conceal 
the  comparatively  poor  results  then  achieved.  It  has  been 
stated  in  some  quarters  that  if  the  False  Statements  (Com- 
panies) Bill,  1904,  were  passed,  it  would  be  impossible,  in  Eng- 
land, for  directors  to  ever  maintain  a  secret  reserve  without 
committing  a  criminal  offence.  This,  it  is  thought,  is  an  ex- 
aggeration. It  is,  however,  important  that  both  directors  and 
auditors  should  bear  in  mind  that  the  mere  fact  that  secret 
reserves  exist  proves  that,  to  some  extent  at  least,  the  directors 
are  not  entirely  candid  with  their  stockholders ;  and  the  absence 
of  absolute  candor  naturally  necessitates  at  the  very  least  the 
most  scrupulous  care  in  connection  with  all  matters  relating  to 
the  accounts. 

CIVIL  LIABILITY  OF  AUDITORS. 

In  England  there  are  two  kinds  of  procedure  under  which 
civil  proceedings  may  be  taken  against  auditors  for  damages 
occasioned  by  negligent  or  unskilful  discharge  of  the  duties 


310  AUDITING. 

imposed  upon  them — namely,  by  way  of  action,  and  by  way  of 
misfeasance  summons. 

In  the  United  States  the  latter  is,  of  course,  in  the  absence 
of  laws  providing  that  a  professional  auditor  could  under 
any  circumstances  be  an  officer  of  a  company,  unknown,  but 
the  procedure  by  way  of  action  is  general.  There  are,  of 
course,  differences  in  practice  in  the  various  jurisdictions,  but 
the  procedure  by  way  of  action  is  believed  to  be  practically  the 
same. 

As  before  mentioned,  no  American  cases  bearing  on  this 
subject  have  been  found,  and  the  English  decisions  will  have 
to  be  considered. 

PROCEDURE  BY  WAY  OF  ACTION.— One  of  the  lead- 
ing English  cases  under  this  procedure  is  the  Leeds  Estate 
Building  and  Investment  Society,  Lim.,  v.  Shephard,  which 
was  decided  by  Mr.  (now  Lord)  Justice  Stirling  in  1887.  This 
case  will  be  found  duly  reported  in  Appendix  "  A,"  and  should 
receive  the  careful  attention  of  the  reader  on  account  of  its 
importance.  The  head-note  of  the  official  report  is  also  of 
considerable  interest;  it  reads  as  follows: — 

"  Held,  that  it  was  the  duty  of  the  auditor  in  verifying  the 
accounts  of  the  company,  not  to  confine  himself  to  verifying 
the  arithmetical  accuracy  of  the  balance  sheet,  hut  to  inquire 
into  its  special  accuracy,  and  to  ascertain  if  it  contained  the 
particulars  specified  in  the  articles  of  association,  and  was 
properly  drawn  up  to  contain  a  true  and  accurate  representa- 
tion of  the  company's  affairs/' 

That  portion  of  the  judgment  which  more  particularly  af- 
fects auditors  enforces  the  same  doctrine  in  even  more  definite 
terms : — 

"In  each  of  (these)  years,  L.  (the  auditor)  certified  that  the  ac- 
counts were  a  true  copy  of  those  shown  in  the  books  of  the  company. 
That  certificate  would  naturally  be  understood  to  mean  that  the  books 
of  the  company  showed  (taking,  for  example,  the  certificate  for  the 
year  1879)  that,  on  the  30th  April,  1879,  the  company  was  entitled  to 


CIVIL  LIABILITY  OF  AUDITORS.  3II 

'moneys  lent'  to  the  amount  of  approximately  $150,000,  This  was  not 
in  accordance  with  the  fact;  the  accounts,  in  this  respect,  did  not  truly 
represent  the  state  of  the  company's  affairs,  and  it  was  a  breach  of 
duty  upon  L.'s  part  to  certify  as  he  did  with  reference  to  them.  The 
payment  of  the  dividends,  directors'  fees,  and  bonuses  to  the  manager 
actually  paid  on  those  years  appears  to  be  the  natural  and  immediate 
consequence  of  such  breach  of  duty;  and  I  hold  L.  liable  for  damages 
to  the  amount  of  the  moneys  so  paid." 

The  futility  of  an  auditor  attempting  to  escape  his  just  re- 
sponsibilities by  a  limitation  of  the  scope  of  his  certificate  is 
here  most  forcibly  demonstrated ;  there  are,  however,  two  other 
points,  which  must  not  pass  unnoticed. 

First,  there  was  no  question,  in  this  case,  as  to  the  accounts 
being  false.  The  matter  in  dispute  was  no  moot  question  of 
depreciation,  or  of  apportionment  between  capital  and  rev- 
enue ;  the  accounts  were  indisputably  false,  and  it  was  not  even 
suggested  that  the  auditor  had  done  his  best  to  verify  their 
accuracy. 

Secondly,  the  immediate  result  of  his  neglect  was  a  pay- 
ment of  dividends,  directors'  fees  and  bonuses.  Had  no  such 
result  taken  place,  it  is  by  no  means  so  certain  that  any  lia- 
bility would  have  accrued. 

Before  dismissing  this  case  altogether,  it  may  be  well  to 
remark  that  the  defendant  was  allowed  the  benefit  of  the 
Statute  of  Limitations;  but — inasmuch  as  this  point  was  not 
disputed  by  plaintiff's  counsel,  and  was  consequently  not  be- 
fore the  court — it  does  not  follow  that  a  like  plea  would  avail 
upon  another  occasion. 

Astrachan  Steamship  Company  Case. — This  was  an  action 
brought  in  the  Palatine  Court  at  Liverpool  to  recover  damages 
from  the  auditors  on  account  of  loss  sustained  by  the  com- 
pany through  the  dishonesty  of  its  manager.  A  settlement 
was  arrived  at  by  the  parties,  so  that  no  new  point  was  decided 
as  to  the  liability  of  auditors,  but  it  may  be  mentioned  in 
passing  that  the  Vice-Chancellor  expressed  some  doubt  as  to 
his  jurisdiction  to  try  the  matter,  and  only  proceeded  upon 


312  AUDITING. 

being  satisfied  that  he  did  so  with  the  consent  of  all  parties. 
In  this  case  a  group  of  steamship  companies  were  administered 
by  the  same  manager,  who  was  eventually  adjudicated  bank- 
rupt with  a  large  deficiency,  and  subsequently  convicted  for 
embezzlement.  It  appeared  that  he  was  able  to  satisfy  the 
auditors  as  to  the  existence  of  the  balance  of  cash  in  hand 
in  the  case  of  each  company  by  producing  to  them  a  sufficient 
sum  of  cash,  although  it  would  have  been  impossible  for  him  to 
simultaneously  produce  a  large  enough  balance  to  cover  the 
amount  that  ought  to  have  been  in  hand  in  respect  of  all  the 
companies  that  he  managed.  Apart  from  this,  however,  it 
appeared  that  he  had  made  entries  in  the  books  of  the  Astra- 
chan  Company,  showing  that  he  had  borrowed  certain  sums 
from  that  company  at  interest,  and  the  suggestion  was  that  a 
transaction  of  this  kind  was  sufficiently  unusual  to  make  it  the 
duty  of  the  auditors  to  call  the  attention  of  the  stockholders  to 
the  fact,  more  especially  as — there  being  no  board  of  directors 
— the  stockholders  were  entirely  dependent  upon  the  auditor 
for  protection. 

POSSIBLE  LIMITS  TO  LIABILITY. 

It  has  already  been  stated  that,  in  the  cases  quoted  above, 
the  measure  of  damages  incurred  by  the  negligent  auditor  has 
been  the  full  amount  wrongfully  paid  out  in  dividends.  This 
raises  the  very  important  questions  as  to  how  far  these  cases 
can  be  relied  upon  as  precedents  in  the  event  of  the  auditor's 
negligence  being  proved,  but 

( 1 )  No  dividend  having  been  paid ; 

(2)  A  dividend  having  been  paid,  and  the  company  having 

since  gone  into  liquidation,  but  there  being  sufficient 
assets  to  pay  all  costs  and  all  creditors  in  full. 

It  is  hardly  to  be  supposed  that  in  either  of  these  cases  the 
auditor  would  incur  wo-  liability,  but  a  very  little  considera- 
tion will  suffice  to  show  that  a  different  mode  of  assessing 
damages  would  have  to  be  adopted.     It  may  be  added  here, 


POSSIBLE    LIMITS    TO    LIABILITY.  313 

however,  that  although  the  practice  of  the  English  Courts  has 
hitherto  been  to  give  judgment  jointly  and  severally  against 
all  respondents  held  liable  for  the  full  amount  of  dividends 
improperly  paid,  with  costs  (without  any  corresponding  right 
of  contribution  inter  se),  it  by  no  means  follows  that  this 
course  will  always  be  pursued.  The  language  of  Section  lo 
is  "  to  repay  the  money  or  property  .  .  .  or  to  contribute 
such  sums  to  the  assets     ...     as  the  Court  thinks  just." 

In  this  connection  the  decision  in  re  Moxham  v.  Grant  "^ 
will  be  found  of  interest.  Here  the  directors  had  been  found 
liable  to  refund  to  the  liquidator  of  the  company  certain  divi- 
dends improperly  paid  out  of  capital,  under  circumstances 
which  conveyed  to  the  stockholders  a  knowledge  of  the  nature 
of  the  source  from  which  dividends  were  declared.  It  was 
held  that  the  directors  had  a  right  to  recover  from  the  various 
stockholders  the  amount  of  their  respective  dividends. 

To  sum  up,  it  does  not  appear  that  the  conscientious  and 
capable  auditor,  who  has  endeavored  to  conduct  his  audit 
upon  the  lines  laid  down  in  this  work,  need  feel  much  appre- 
hension as  to  the  legal  consequences  arising  from  a  bona  Ude 
error  of  judgment,  or  from  his  inability  to  discover  an  ex- 
ceptionally clever  fraud.  On  the  other  hand,  it  is  doubtless 
greatly  to  the  advantage  of  all  properly  qualified  auditors  if 
a  reasonable  measure  of  responsibility  be  expected  from  them, 
for  there  is  then  some  chance  of  scaring  out  of  the  field  a  too 
numerous  class  of  so-called  auditors,  whose  extreme  ignor- 
ance of  the  veriest  elements  of  their  profession  is  only  equalled 
by  their  utter  inability  to  appreciate  the  moral  responsibility 
of  their  position.  It  is  believed  that  abuses  rarely  occur,  and 
that,  consequently,  all  competent  and  reputable  accountants 
may  regard  the  matter  as  something  that  does  not  in  any  sense 
intimately  concern  them. 

In  order  that  the  reader  who  is  especially  interested  in  the 
purely  legal  aspect  of  an  auditor's  responsibility  may  have  the 

*(Dicksee's  Auditing,  Seventh  English  Edition,  page  689.) 


314  AUDITING. 

benefit  of  the  leading  English  cases,  many  of  them  will  be 
found  reported  in  Appendix  "  A." 

The  reported  cases  are  preceded  by  a  general  summary,  or 
rules,  of  the  English  law  as  laid  down  in  these  decisions,  and 
until  an  authoritative  American  case  appears  the  rules  so  de- 
duced may  be  fairly  considered  as  American  law.  This,  at 
least,  is  the  opinion  of  the  attorney  who  prepared  them. 

It  must  he  home  in  mind,  however,  that  the  authors  of  this 
volume  advocate  far  more  rigid  rules  for  professional  auditors 
than  the  law  seems  to  require.  The  rules  of  law  are  simply 
given  for  information  and  not  as  recommendations. 


CHAPTER  XL 


INVESTIGATIONS. 


It  has  been  thought  desirable  to  devote  a  chapter  to  that 
special  phase  of  the  subject  which  is  usually  known  as  an 
"  Investigation."  The  subject  is  one  intimately  connected 
with  auditing,  but  possesses  many  peculiar  features  which 
cannot  afford  to  be  overlooked. 

PURPOSES  OF  INVESTIGATIONS. 

An  investigation — so  far  as  present  purposes  are  concerned 
— may  be  described  as  "A  special  audit,  undertaken  for  a  par- 
ticular purpose."  The  particular  purposes  for  which  an  inves- 
tigation is  usually  made  are  as  follows : — 

I.  Upon  the  sale  of  an  undertaking :  j 

(a)  To  a  public  company. 

(b)  To  a  private  purchaser,  or  purchasers. 

(c)  To  a  continuing  partner,  or  partners,  by  a  retiring 

partner,  or  partners. 

II.  For  the  purpose  of  obtaining  special  information  as  to 
the  position  of  an  undertaking: 

(d)  On  behalf   of   a   committee   of   investigation   ap- 

pointed by  stockholders. 

(e)  On  behalf  of  a  present  or  prospective  creditor. 
(/)  With  a  view  to  the  discovery  of  suspected  fraud. 

The  former  group  alone  claims  attention  in  this  work. 

315 


3l6  AUDITING. 

EXTENT  OF  INVESTIGATIONS. 

When  making  an  investigation  of  any  kind  it  must  not  be 
forgotten  that  those  relying  upon  the  accountant's  report  will 
naturally,  and  indeed  reasonably  take  it  for  granted  that,  so 
long  as  they  adequately  explain  their  object  in  seeking  his 
assistance,  it  is  for  him,  as  an  expert,  to  decide  both  as  to  the 
nature  and  the  extent  of  the  examination  itself ;  and  in  the 
event  of  its  being  subsequently  discovered  that  an  investigation 
had  failed  to  achieve  its  intended  object,  the  accountant  would 
be  required  to  show  that  such  failure  did  not  arise  from  any 
cause  which  could  have  been  prevented  by  a  more  complete, 
or  a  more  exhaustive  examination.  Cases  are  not  unknown  in 
which  a  faulty  investigation  has  been  attempted  to  be  shielded 
under  the  plea  that  special  instructions  had  been  given  by  the 
client,  and  that  such  instructions  had  been  duly  carried  out ;  it 
being  argued  that  where  the  client  has  given  special  instruc- 
tions as  to  the  course  to  be  pursued,  the  accountant  must  be 
exonerated  from  any  mishap  arising  from  the  defectiveness 
of  those  instructions.  This  doctrine  appears  to  be  a  most 
dangerous  one.  There  can  be  no  doubt  that  whatever  instruc- 
tions the  accountant  may  have  received  were  intended  rather 
as  a  description  of  the  object  to  be  effected  than  as  a  definite 
requirement  as  to  the  means  by  which  that  object  was  to  be 
attained.  It  goes  without  saying  that  the  best  authority  as  to 
the  means  to  be  employed  must  be  the  accountant  himself  (who 
receives  his  instructions  by  virtue  of  his  being  an  expert  in 
the  matters  requiring  investigation),  and  it  would  thus  seem 
that — however  desirable  it  may  be  that  he  should  receive,  and 
even  welcome,  suggestions  as  to  the  modus  operandi  of  his 
work — an  accountant  cannot  submit  his  professional  discretion 
to  the  dictation  of  his  clients  without  sacrifice  of  self-respect 
and  grave  danger  to  his  clients'  interests.  An  accountant  who 
undertakes  the  responsibility  of  an  investigation  ought  not  to 
seek  to  shield  himself  from  the  implied  responsibility  of  pro- 
ceeding upon  that  investigation  on  the  lines  which  his  profes- 
sional experience  convinces  him  are  the  proper  ones. 


DETECTION  OF  ERRORS  IN  BOOKS.  317 

The  position  of  the  investigating  accountant,  when  only 
incomplete  sets  of  books  are  available,  is  a  question  of  very 
considerable  importance.  So  long  as  the  books  are  sufficiently 
complete  to  enable  the  accountant  to  reasonably  arrive  at  the 
conclusion  that  (so  far  as  they  go)  they  are  accurate,  there 
can,  it  is  thought,  be  no  objection  to  his  issuing  a  report  con- 
fined to  such  matters  as  the  books  may  show.  But  there  is  a 
danger  of  the  whole  system  of  investigation  falling  into  dis- 
credit, if  accountants  go  too  far,  and  substitute  for  certificates 
of  actually  accompHshed  facts  statements  so  qualified  as  to 
amount,  in  effect,  to  but  little  more  than  a  carefully  safe- 
guarded expression  of  opinion.  It  should  be  borne  in  mind 
that  the  object  of  any  form  of  accountant's  certificate  or  re- 
port, included  in  a  company  prospectus,  is  to  satisfy  intending 
investors,  and  that  such  persons  do  not,  as  a  matter  of  fact, 
by  any  means  always  carefully  study  the  wording  of  the  re- 
port, or  certificate,  referred  to.  Unless,  therefore,  an  account- 
ant has  really  something  to  certify  he  should  studiously  refrain 
from  issuing  any  statement  of  opinion,  or  estimate,  in  the  form 
of  a  certificate. 

DETECTION  OF  ERRORS  IN  THE  BOOKS. 

Before  proceeding  to  consider  the  subject  in  further  detail, 
it  would  appear  desirable  to  clear  up  a  point  which  is  of  the 
greatest  importance,  and  upon  which  a  considerable  difference 
of  opinion  appears  to  exist — viz.,  the  position  of  the  account- 
ant who  has  certified  as  to  profits  which,  in  consequence  of  the 
falsification  of  the  accounts  investigated,  have  subsequently 
proved  to  have  been  overstated.  There  appears  to  be  no  deci- 
sion directly  bearing  upon  this  point;  but  a  case  which  came 
before  Lord  Kyllachy  at  the  Court  of  Session  in  Edinburgh,  in 
1892,  is  of  considerable  interest.  The  case  was  that  of  the 
Edinburgh  United  Breweries,  Lim.,  &c.,  v.  James  A.  Molleson 
{Nicholson's  Trustee) ^  &c.,*  and  the  question  then  at  issue  was 
as  to  whether  the  circumstance  that  the  profits  disclosed  by 


*  Dicksee's  Auditing,  Seventh  English  Edition,  page  620. 


3l8  AUDITING. 

the  books  of  the  Palace  Brewery,  Edinburgh,  were  in  excess 
of  the  amount  actually  made  was  (in  the  absence  of  fraud  on 
the  part  of  the  vendors)  a  sufficient  ground  for  the  cancellation 
of  the  purchase,  or  for  damages.  It  will  be  seen  that  this  case 
has  only  an  indirect  bearing  upon  the  point  now  being  consid- 
ered ;  indeed,  the  interest  which  it  possesses  is  dependent  rather 
upon  the  nature  of  the  evidence  than  upon  the  point  actually 
at  issue.  Especially  must  it  be  borne  in  mind  that,  although 
Lord  Kyllachy's  decision  was  upheld  upon  appeal,  it  was 
merely  upheld  because  it  was  considered  that  the  plaintiff  had 
no  right  of  action  against  the  defendant,  no  opinion  being 
expressed  by  the  Court  of  Appeal  upon  Lord  Kyllachy's  views. 
At  the  original  hearing  of  the  case  it  was  contended  on  the 
one  side  that  books  submitted  to  accountants  for  examination 
were  to  be  taken  as  warranted  free  from  falsification;  while, 
on  the  other  hand,  it  was  argued  that  it  was  not  the  custom 
for  any  such  warranty  to  be  implied,  and  that  a  proper  inves- 
tigation of  the  accounts  should  have  disclosed  the  fact  that  the 
profits  had  been,  more  or  less,  overstated.  In  giving  his  judg- 
ment, his  Lordship  stated  that  it  appeared  to  him  that  the 
question  was  as  to  whether  it  was  a  condition  of  the  contract 
of  sale,  expressed  or  implied,  that  the  books  of  the  brewery 
were  to  contain  no  errors,  or,  at  least,  no  errors  that  were 
not  easily  to  be  discovered,  and  he  confessed  his  inability  to 
discover  any  reason  for  so  holding.  He  could  find  no  stand- 
ard according  to  which  the  purchaser's  examination  of  the 
books  was  to  be  conducted,  and  he  was,  therefore,  unable  to 
hold  that  the  plaintiffs  were  entitled  to  re-open  the  contract, 
and  now  raise  the  question  as  to  whether  a  condition  as  to  the 
amount  of  profits  had  been  fulfilled.  The  chief  point  in  this 
decision  which  is  really  of  interest  in  the  present  inquiry  is 
the  finding  that  there  does  not  exist  in  a  contract  for  sale 
based  upon  a  statement  of  profits  an  implied  condition  that 
such  statement  is  correct.  Exception  must,  of  course,  be 
taken  in  the  case  of  a  fraudulent  mis-statement,  for  naturally 
such  contracts  would  be  voidable  upon  proof  of  fraud.  The 
question  remains,  however,  that  if  the  vendors  have  acted  bona 


DETECTION  OF  ERRORS  IN  BOOKS.  319 

Me  there  is  no  redress  for  the  purchasers  if  they  have  given 
too  large  a  price  for  an  undertaking  in  consequence  of  an  in- 
correct statement  of  profits  by  the  vendors  (provided  the  pur- 
chasers have  had  an  opportunity  of  verifying  such  statement), 
or  in  consequence  of  a  statement  of  profits  that  has  been  falsi- 
fied— it  may  be  by  some  employee  of  the  vendors,  unknown  to 
them.  It  would  therefore  appear  that,  in  such  a  case,  an  inves- 
tigation that  failed  to  reveal  the  actual  condition  of  affairs 
would  have  failed  to  achieve  its  most  important  object.  In 
the  case  of  Short  &  Compton  v.  Brackett  (vide  Appendix  "A") 
it  was  expressly  decided  by  Judge  Tindal  Atkinson  that  an 
investigating  accountant  is  entitled  to  "  assume ''  the  accuracy 
of  the  figures  appearing  in  the  books. 

Opinions  of  Accountants  thereon. — It  is  not  proposed  to 
fully  discuss  the  legal  position  and  responsibilities  of  an  inves- 
tigating accountant  under  such  circumstances,  nor  to  criticise 
the  investigation  that  was  made  in  The  Edinburgh  United 
Breweries'  case ;  but  as  there  is  much  that  is  deserving  of  atten- 
tion in  the  various  opinions  that  were  expressed  by  the  expert 
witnesses  who  appeared  in  that  case,  the  opinions  of  these 
witnesses  are  shortly  stated  here. 

Each  of  the  following  extracts  represents  the  opinion  of  a 
different  accountant: — 

"There  is  a  difference  between  checking  books  and  investigating 
profits,  and  that  an  investigation  of  profits,  even  if  properly  conducted, 
would  not  always  reveal  an  actual  misstatement  thereof." 

"  In  making  such  investigations  I  do  not  consider  it  any  part  of  my 
duty  to  go  through  all  the  books  and  vouchers  as  in  the  case  of  a  regu- 
lar audit." 

"  In  investigating  the  profits  of  a  business  with  reference  to  a  sale, 
my  experience  is  that  an  accountant  is  not  expected  to  check  the  books 
and  entries  for  the  purpose  of  tracking  falsifications.  There  is  a 
marked  difference  between  an  audit  and  an  investigation  with  a  view 
to  profits.  The  falsifications  in  this  case  could  not  have  been  discov- 
ered without  a  comparison  of  the  postings  in  one  set  of  books  into 
another,  and  I  hold  that  is  no  part  of  the  duty  of  an  accountant  turned 


320  AUDITING. 

on  to  investigate  profits.    Personally,  I  always  insert  the  words  '  assum- 
ing the  accuracy  of  the  books  *  in  my  certificate." 

"  It  is  not  the  custom  in  such  cases  to  examine  the  books  in  detail. 
Accountants  consider  that  they  are  entitled  to  assume  the  genuineness 
of  the  books." 

A  leading  solicitor  expressed  the  opinion  that  accountants, 
when  instructed  to  investigate  into  the  profits  of  a  company, 
were  not  expected  to  go  into  such  details  as  would  have  been 
necessary  to  discover  the  falsifications  in  this  particular  case. 

On  the  other  hand: — 

"  A  proper  examination  would  have  discovered  the  falsifications ; 
I  consider  that  an  accountant  pursuing  an  investigation  that  would  be 
useful  would  wish  to  analyze  the  accounts,  and  if  this  had  been  done 
the  frauds  would  have  been  discovered." 

"The  falsifications  should  have  been  discovered;  I  consider  that 
an  examination  of  the  individual  (trade)  accounts  was  necessary  to 
form  a  correct  idea  of  the  nature  of  a  business,  and  had  this  been 
done  the  frauds  would  have  been  discovered." 

It  is  altogether  likely  that  if  expressions  of  opinion  upon 
this  case  were  requested  from  the  same  number  of  American 
practitioners  the  answers  would  correspond  very  closely  with 
those  quoted  above,  i.  e.,  support  would  be  given  to  both  sides 
of  the  controversy. 

In  speaking  of  the  object  of  these  examinations,  the  writer 
of  an  article  that  appeared  in  The  Accountant  at  the  time 
says :  "  What  the  public  seem  to  want  is,  not  the  nearest  ap- 
proach to  facts  that  can  be  obtained  in  so  many  days  or  weeks, 
but  the  nearest  approach  to  facts  that  is  humanly  possible." 
This  will  be  found  to  accurately  express  the  views  of  the 
average  layman. 

INVESTIGATION  ON  BEHALF  OF  PROJECTED 
COMPANY. 

(a)  For  the  purpose  of  pursuing  this  inquiry  in  further 
detail,  it  is  proposed  to  narrow  the  field  down  to  the  question 
of  investigations  made  on  behalf  of  a  projected  company.     The 


INVESTIGATION  ON  BEHALF  OF  PROJECTED  COMPANY.      32I 

following  suggestions  will,  therefore,  also  cover  sub-heading 
(b).  The  most  convenient  method  of  dealing  with  the  subject 
will  be  to  contrast  the  methods  to  be  adopted  in  such  an  inves- 
tigation with  those  ordinarily  employed  in  a  regular  audit. 

From  a  theoretical  point  of  view  there  need,  of  course,  be 
no  difference  of  method;  for  both  audits  and  investigations 
aim  at  a  complete  disclosure  of  the  facts.  In  practice,  how- 
ever, it  is  usual  to  restrict  the  inquiry,  so  far  as  is  possible, 
without  imperilling  the  efficiency  of  the  examination;  and  it 
is  because  the  objects  of  an  audit  are  not  altogether  the  same 
as  those  of  an  investigation  that  the  method  adopted  in  each 
case — i.  e.,  the  abbreviated,  practical  method — ^varies  some- 
what. 

LIMITS  OF  AN  INVESTIGATION.— A  regular  audit 
professes  to  discover  the  true  position  of  affairs.  An  investi- 
gation as  to  profits,  made  on  behalf  of  a  proposed  company, 
professes  to  discover  the  position  of  affairs  so  far  as  they 
affect  the  particular  object  in  view.  In  some  respects  the 
narrower  field  of  an  investigation  will  permit  the  accountant 
to  reduce  the  scope  of  his  examination ;  but,  on  the  other  hand, 
there  would  appear  to  be  many  points  upon  which  a  greater 
strictness  of  inquiry  is  necessary.  Thus,  supposing  the  ac- 
countant to  be  acting  upon  behalf  of  the  purchasers  of  an 
undertaking,  he  may  take  it  for  granted  that  the  accounts 
submitted  to  him  by  the  vendors  do  not  underestimate  the 
profitable  nature  of  the  business,  or  the  strength  of  its  financial 
position.  Consequently,  it  does  not  seem  necessary  that  he 
should  inquire  with  the  same  exhaustiveness  that  he  would  use 
in  the  case  of  an  audit  into  the  completeness  with  which  every 
source  of  income  has  been  duly  accounted  for ;  neither  does  it 
appear  necessary  for  him  to  consider  the  validity  of  the 
various  items  of  expenditure  charged  in  the  accounts,  nor  to 
compare  such  expenditure  minutely  with  the  vouchers.  On 
the  other  hand,  if  he  is  acting  on  behalf  of  the  vendors,  it  is 
clearly  desirable  that  both  these  points  should  receive  careful 
attention,  but  in  that  case  the  investisration  would  not  differ 


322  AUDITING. 

greatly  from  the  complete  audit;  for  it  is  obvious  that  he 
could  not  authorize  the  submission  of  accounts  to  the  proposed 
purchasers  until  he  was  satisfied  that  such  accounts  were  true 
in  all  respects. 

FRAUD  IN  ACCOUNTS.— Yet  another  difference  between 
investigations  and  audits  will  not  fail  to  strike  the  observer. 
An  ordinary  audit  must  always  aim  at  the  discovery  of  fraud ; 
but  an  investigation  as  to  profits  would  not  appear  to  involve 
any  such  inquiry,  except  in  so  far  as  the  assets  or  profits 
might  have  been  fraudulently  overstated  for  the  purpose  of 
concealing  defalcations,  or  of  deliberately  making  the  accounts 
appear  unduly  favorable. 

Broadly  speaking,  there  are  two  ways  in  which  books  may 
be  falsified  for  the  purpose  of  concealing  fraud.  The  first 
method  is  by  falsifying  the  balance  sheet,  either  overstating 
assets  or  understating  liabilities  to  cover  the  amount  stolen; 
the  second  method  is  by  falsifying  the  revenue  account,  by 
understating  income  or  overstating  expenses,  so  that  the  profit 
shown  by  the  books  may  be  reduced  to  the  profit  which  was 
actually  netted  by  the  proprietors,  after  deducting  the  amount 
misappropriated   by   the   defaulter. 

If  the  first  method  has  been  adopted,  the  purchasers  will 
not  necessarily  be  prejudiced,  for  the  profits  shown  by  the 
books  will  have  been  the  profits  actually  made ;  while  the 
assets  which  appear  in  the  books  at  an  unduly  inflated  price 
will  usually  be  guaranteed  as  to  the  value  by  the  vendors,  or 
else  vouched  for  by  the  certificate  of  an  independent  valuer. 
Sometimes,  however,  the  investigating  accountant  assumes  re- 
sponsibility for  the  accuracy  of  the  scheduled  book  debts 
taken  over  by  the  proposed  company,  and  in  such  cases  it  will, 
of  course,  be  necessary  for  him  to  carefully  inquire  into  their 
correctness. 

On  the  other  hand,  the  defalcations,  if  considerable,  are 
likely  to  be  concealed  by  a  falsification  of  balance  sheet  items 
rather  than  of  revenue  items,  for  any  material  understatement 


INVESTIGATION  ON  BEHALF  OF  PROJECTED  COMPANY.       323 

of  profits,  such  as  would  be  involved  by  the  last-named  form 
of  falsification,  would  be  extremely  dangerous,  as  drawing 
prominent  attention  to  the  existence  of  a  leakage.  A  falsifica- 
tion of  balance  sheet  items,  wnth  a  view  to  concealing  defalca- 
tions, ought  not  to  escape  the  attention  of  the  investigating 
accountant ;  not,  of  course,  because  he  is  necessarily  responsible 
for  the  values  attached  to  the  various  assets  and  liabilities  in 
the  balance  sheets  of  the  undertaking  about  to  be  purchased, 
but  because  he  cannot  safely  include,  in  his  certificate  of  past 
profits,  profits  actually  earned  by  the  undertaking  which,  owing 
to  the  dishonesty  of  its  employees,  never  went  into  the  pockets 
of  its  proprietors. 

Under  the  second  method  it  would  appear  that  the  pur- 
chasers would  actually  gain  by  the  defalcations  of  an  official 
of  the  vendors,  for  the  profits  earned  would  be  in  excess  of 
those  shown  by  the  books,  while  the  latter  would  form  the 
basis  upon  which  the  purchase  price  for  goodwill  was  calcu- 
lated; and,  as  the  balance  sheet  would  correctly  record  the 
financial  position,  there  would  obviously  be  no  injustice  done 
to  the  purchasers,  if  these  figures  were  taken  as  a  basis  for 
valuation.  It  is  thought,  therefore,  that  the  investigating  ac- 
countant acting  on  behalf  of  a  proposed  company  need  not 
trouble  to  go  exhaustively  into  the  question  of  the  bo7ia  fides 
of  the  various  expenses  debited,  his  great  object  being  to  make 
sure  that  the  expenses  are  completely  recorded  in  the  books 
submitted  to  him.  On  the  other  hand,  he  will  require  to  look 
carefully  into  the  bona  fides  of  many  transactions,  which  the 
auditor  would  naturally  pass  either  unquestioned,  or,  at  all 
events,  after  due  representation  of  the  circumstances  to  his 
clients.  The  difficulty  of  the  investigating  accountant's  posi- 
tion arises  from  the  fact  that  his  real  clients  (  i.  e.,  those  in 
whose  interests  he  is  acting)  are  an  unknown,  and,  at  that 
time,  non-existent  body.  It  is,  therefore,  obviously  impossible 
for  him  to  consult  them  in  any  way  during  the  course  of  his 
investigation,  and  his  only  means  of  acquainting  them  with  the 
result  of  his  inquiry  will  be  by  means  of  his  certificate. 


3^4  AUDITING. 

SCOPE  OF  CERTIFICATE.— In  making  an  investigation 
as  to  profits,  therefore,  the  accountant  must  be  careful  never 
to  lose  sight  of  the  object  for  which  his  investigation  is  being 
made.    That  object  may  be  said  to  be  to  ascertain 

(a)  Whether  the  business  of  the  vendors  is  worth  purchas- 

ing. 

(b)  Whether  such  business  is  worth  the  price  asked  for  it 

by  the  vendors. 

The  accountant  is  not  actually  asked  to  express  a  definite 
opinion  upon  either  of  these  points,  for  it  is  obviously  the 
business  of  each  intending  stockholder  to  answer  these  ques- 
tions to  his  own  satisfaction  before  applying  for  shares,  but 
it  is  pointed  out  that  the  accountant's  certificate  forms  almost 
the  sole  basis  upon  which  the  stockholder  can  judge  of  the 
prospects  of  the  proposed  company,  and  it  is  therefore  argued 
that  it  should  be  the  accountant's  aim  to  so  conduct  his  inves- 
tigation, and  so  frame  his  certificate,  that  the  materials  neces- 
sary for  a  correct  judgment  may  be  placed  before  the  public. 
At  the  same  time  it  cannot  be  too  strongly  insisted  upon  that 
an  accountant's  certificate  as  to  profits,  relating  as  it  does  to 
past  events,  deals  with  a  subject-matter  that  ought  to  be  cap- 
able of  absolute  verification.  The  certificate,  therefore,  should 
be  a  clear  and  unconditional  certificate  of  accomplished  facts, 
and  not  a  mere  estimate  of  possible — or  even  probable — future 
results,  misnamed  a  "  certificate."  To  the  limited  extent 
already  mentioned  it  may  be  permissible,  and  even  desirable, 
lo  modify  the  past  results  so  that  they  may  more  usefully  serve 
the  purpose  for  which  they  are  primarily  intended — namely, 
provide  a  reliable  index  of  future  profits.  But  at  the  same 
time  a  certificate  should  relate  not  to  the  future,  but  to  the 
past;  and  intending  investors  would  do  well  to  bear  in  mind 
that,  unless  a  definite  statement  as  to  the  past  is  provided  in 
a  company  prospectus,  the  reasonable  assumption  is  that  the 
past  profits  have  been  unsatisfactory. 


INVESTIGATION  ON  BEHALF  OF  PROJECTED  COMPANY.      325 

There  is  yet  another  point  which  the  accountant  must  not 
fail  to  bear  in  mind.  Inasmuch  as  he  may  be  required  at  any 
future  date  to  substantiate  the  statements  that  he  has  certi- 
fied, he  should  not  fail  to  make  the  most  copious  notes  of  all 
that  transpires  during  the  course  of  his  investigation.  These 
notes  should  not  be  confined  to  actual  figures  and  calculations : 
whatever  explanations  he  may  have  received  in  reply  to  his 
inquiries  should  be  committed  to  writing,  so  that  they  may  be 
available  if  required.  If  this  be  not  attended  to,  and  legal 
proceedings  are  subsequently  instituted  requiring  the  account- 
ant to  substantiate  his  report,  his  position  will  not  be  an  envi- 
able one,  for  he  will  probably  have  to  go  over  at  least  a  por- 
tion of  the  ground  a  second  time,  and  perhaps  some  of  the 
evidence  he  formerly  utilized  may  no  longer  be  available. 

LENGTH  OF  PERIOD  TO  BE  INVESTIGATED.— 
It  is  generally  held  that  it  is  no  part  of  the  accountant's  duty 
to  prescribe  the  term  of  years  over  which  his  inquiry  should 
extend.  It  is,  however,  desirable  to  bear  in  mind  the  im- 
portance of  expressly  stating  in  the  certificate  the  period  that 
has  been  covered  by  the  investigation;  and,  further,  it  is  ab- 
solutely essential  that  the  inquiry  should  be  brought  reason- 
ably up  to  date.  It  may  be  found  convenient  to  report  only 
upon  the  results  of  completed  years,  but  the  odd  months  elaps- 
ing between  the  date  of  the  last  balance  sheet  and  the  date  of 
the  investigation  should  not  escape  notice,  and  if  they  show 
any  material  falling  off,  the  fact  ought  not  to  escape  attention. 
It  may  be  added  here  that  it  is  very  desirable  that  the  ac- 
countant's certificate  should  separately  state  the  profits  of  each 
year  covered  by  the  investigation. 

METHOD  OF  PROCEDURE.— Standing  op  Vendors.— 
Before  actually  commencing  an  investigation  it  is  very  de- 
sirable to  make  inquiries  as  to  the  position  and  character  both 
of  the  promoters  and  the  proprietors  of  the  undertaking.  A 
man  is  always  apt  to  be  known  by  the  company  he  keeps,  and 
no  one  can  aflford  to  be  mixed  up  with  persons  of  more  or  less 
doubtful  reputation.     Moreover,  if  a  man  bears  a  really  bad 


326  AUDITING. 

character,  it  may  safely  be  taken  as  being  as  least  probable 
that  the  company  in  which  he  is  concerned  is  not  likely  to 
prove  a  very  good  investment  to  the  public ;  and  an  accountant 
is  not  likely  to  do  himself  much  good  by  mixing  himself  up 
with  unprofitable  companies. 

System  of  Accounts. — The  next  point  that  claims  atten- 
tion is  the  general  system  upon  which  the  books  have  been 
kept.  And,  in  this  connection,  it  may  be  mentioned  that — ^in- 
asmuch as  it  is  very  desirable  that  the  accountant  should  se- 
cure the  co-operation  of  the  employees  of  the  establishment — 
it  is  a  mistake  for  him  to  abuse  the  system  of  accounts  which 
he  finds  in  use,  in  the  presence  of  the  bookkeeper.  Any  such 
want  of  tact  upon  his  part  is  almost  certain  to  put  the  book- 
keeper's back  up,  and  then,  instead  of  information  flowing  in 
smoothly,  it  has  to  be  dragged  out  by  a  course  of  cross-exam- 
ination that  involves  a  heavy  expenditure  of  both  time  and 
temper. 

Audited  Accounts.— If  the  books  have  been  regularly  aud- 
ited by  a  Certified  Public  Accountant  it  is  a  good  plan  to 
seek  an  interview  with  him,  and  endeavor  to  gather  the  precise 
extent  of  his  examination,  and  also  his  general  opinion  upon 
the  matter.  This  course  is,  perhaps,  somewhat  unusual;  but 
clearly  it  cannot  be  regarded  as  objectionable,  while  cases  may 
easily  arise  in  which  it  might  be  a  most  useful  course  to  adopt. 
For  instance,  if  a  thorough  audit  has  been  made  at  regular 
intervals  by  a  competent  and  trustworthy  accountant,  the  in- 
vestigating accountant  might  feel  fairly  safe  upon  most  mat- 
ters of  mere  arithmetical  accuracy,  and  confine  his  attention 
more  exclusively  to  questions  of  principle  and  to  values. 

Unaudited  Accounts. — On  the  other  hand,  if  there  has 
been  no  regular  audit,  and  a  fortiori  if  the  books  have  not  even 
been  regularly  balanced,  it  seems  as  though  he  could  not,  with 
safety,  neglect  an  absolutely  exhaustive  inquiry  into  all  the 
facts.  Of  course,  objections  may  be  raised  to  this  position, 
the  most  important  being  the  objection  that  such  a  complete 


INVESTIGATION  ON  BEHALF  OF  PROJECTED  COMPANY.       327 

examination  would  occupy  a  much  longer  time  than  is  ordi- 
narily available  for  the  purpose.  It  is,  however,  submitted 
that  it  is  the  accountant's  duty  to  make  an  effective  investi- 
gation— not  the  most  effective  investigation  practicable  in  a 
limited  period  of  time — and  further,  that  he  should  so  con- 
duct affairs  that  he  need  not  shrink  from  accepting  the  fullest 
responsibility  as  to  the  extent  of  his  investigations. 

NECESSITY  FOR  INSPECTING  BALANCE  SHEETS. 
— Another  general  point  to  which  it  is  desirable  to  draw  at- 
tention is  the  danger  of  looking  only  to  the  revenue  account 
for  information  as  to  profits.  Cases  are  not  unknown  in 
which — the  assets  being  taken  over  at  an  agreed  valuation — 
the  investigating  accountant  has  confined  his  attention  entirely 
to  the  revenue  account,  without  concerning  himself  with  the 
sufficiency  or  otherwise  of  the  amounts  written  off  for  depre- 
ciation and  bad  debts ;  the  result  being  that  the  certified  profits 
"  as  shown  by  the  books  "  were  greatly  in  excess  of  the  profits 
actually  earned.  The  accountant  who  aims  at  something  more 
than  pocketing  his  fees  and  keeping  his  skin  whole  will  not 
rest  satisfied  with  that  sort  of  investigation. 

GENERAL  COURSE  OF  PROCEDURE.— Assuming  that 
the  accountant  is  about  to  commence  an  investigation  into  the 
profits  of  a  manufacturing  or  trading  concern  during  the  past 
three  (or  more)  years,  with  a  view  to  its  being  purchased  by 
a  private  individual  or  a  corporation ;  the  land,  buildings,  plant 
and  stock-in-trade  being  specially  valued  for  that  purpose  by 
an  independent  appraiser;  assuming  further  that  the  accounts 
have  been  continuously  audited  by  a  firm  of  Certified  Public 
Accountants,  who  are  satisfied  as  to  their  correctness,  the 
question  arises,  What  special  points  will  the  investigating  ac- 
countant require  to  examine  which  do  not  arise  in  the  ordi- 
nary course  of  a  regular  audit? 

Taking  first  the  several  revenue  accounts,  he  will  compare 
these  with  each  other,  and  see  whether  or  not  they  indicate  a 
steady  or  consistent  condition  of  affairs,  whether  the  turn- 


328  AUDITING. 

over  fluctuates  materially,  is  increasing,  at  a  standstill,  or 
diminishing;  whether  the  percentage  of  gross  profit  is  fairly 
constant,  and  such  as  is  usually  earned  in  such  undertakings; 
and  whether  the  percentages  of  expenses  and  net  profit  to 
gross  turnover  are  reasonably  steady.  A  marked  reduction 
of  expenses  during  the  last  year  must  be  viewed  with  the 
greatest  suspicion,  for  such  reduction,  if  excessive  and  not 
bona  Ude,  may  have  a  very  serious  effect  upon  the  future  pros- 
pects of  the  undertaking. 

So  far  as  is  reasonably  practicable,  the  accountant  must 
examine  the  bona  iides  of  all  sales,  especially  those  recorded 
during  the  last  few  months.  The  prices  of  at  least  a  portion 
should  be  compared  with  current  rates,  and  any  remarkable 
increase  in  the  amount  of  sales  or  in  the  number  of  new  ac- 
counts opened  should  be  regarded  with  suspicion.  All  entries 
"  on  approval "  must  be  disallowed,  and  where  sales  are  post- 
dated it  seems  essential  to  make  sure  that  they  have  actually 
gone  out  of  stock.  The  entries  for  the  next  few  weeks  after 
the  closing  of  the  books  should  be  carefully  scanned,  and  if 
they  show  an  exceptionally  large  number  of  returns,  or  an 
exceptionally  small  amount  of  sales,  he  must  draw  his  own 
conclusions  as  to  the  bona  iides  of  such  entries.  In  dealing 
with  the  question  of  consignments,  he  must  remember  that 
the  goods  have  probably  been  invoiced  out  at  selling  prices, 
while  the  unsold  balance  can  only  be  allowed  for  in  the  ac- 
counts at  cost  price  {plus  expenses)  at  most.  Another  point 
which  must  not  be  lost  sight  of  is  the  question  of  travellers' 
commission ;  care  must  be  taken  to  charge  up  commission  upon 
all  sales  that  are  included  in  the  accounts.  Due  allowance 
must  also  be  made  for  all  outstanding  accounts.  Due  allow- 
ance must  also  be  made  for  all  outstanding  discounts;  and 
empties  which  are  returnable,  but  not  yet  returned,  cannot 
safely  be  taken  credit  for  at  the  full  price  charged. 

With  regard  to  the  purchases,  the  problem  is  similar  to  the 
sales,  but  somewhat  simpler,  because  the  accountant  can  usually 
get  hold  of  the  creditor's  statements.     It  is,  however,  very 


INVESTIGATION  ON  BEHALF  OF  PROJECTED  COMPANY.      329 

necessary  to  be  on  ones'  guard  against  the  omission  of  post- 
dated invoices  when  the  goods  have  actually  gone  into  stock. 

Where  reliable  stock  accounts  and  cost  accounts  have  been 
kept,  there  exists  a  very  valuable  corroboration  of  the  con- 
tents of  the  trading  account;  but  where  these  cannot  be  ob- 
tained, the  accountant  must  do  his  best  with  the  material  avail- 
able. 

It  is  especially  important  that  the  various  stock  takings 
should  be  conducted  upon  similar  lines,  i.  e.,  they  should  be 
based  upon  the  same  scale  of  prices,  due  allowance  being  made 
for  the  depreciation  of  articles  no  longer  in  fashion,  or  in 
small  quantities,  or  "  odd  "  sizes. 

If  the  various  stock  lists  have  been  prepared  upon  differ- 
ent scales  of  prices,  they  must  be  recast  upon  a  uniform 
method,  as  any  such  difference  may  very  materially  alter  the 
profits  shown  by  the  accounts.  The  valuation  of  the  stock- 
in-trade  made  by  the  appraiser  should  be  compared  with  the 
vendor's  stock  list,  and  if  there  is  any  material  difference  be- 
tween the  two,  the  accountant  must  not  fail  to  examine  the 
effect  of  such  difference  upon  the  accounts.  Thus,  supposing 
he  arrives  at  the  conclusion  that  throughout  (say)  the  past 
three  years,  the  stock  has  been  consistently  overvalued,  say, 
15  per  cent.,  and  supposing  the  stock  is  $50,000  heavier  at  the 
present  time  than  it  was  three  years  ago,  then  during  those 
three  years  the  net  profits  will  have  been  overstated  $7,500 
or  (say)  $2,500  a  year,  which  is  a  material  difference  when 
one  comes  to  pay  eight  or  ten  years'  purchase  for  a  goodwill. 

When  the  stock  consists  of  such  articles  as  cotton,  iron, 
grain,  lead,  &c.,  which  have  a  definite  but  unstable  market 
value,  the  question  of  the  legitimacy  of  profits  arising  from 
such  alterations  in  value  as  may  have  occurred  is  a  considera- 
tion of  no  slight  importance.  This  is  a  point  upon  which  the 
author  would  rather  not  express  too  decided  a  view  at  the 
present  time,  but  it  is  his  opinion  that  (i)  no  profit  should 
be  taken  credit  for  upon  the  rise  in  value  of  unsold  stock. 


330  AUDITING. 

although  revenue  must  be  debited  with  the  contingent  loss 
arising  from  any  fall;  (2)  no  profit  should  be  included  as 
part  of  the  trading  or  manufacturing  profits  that  has  arisen 
out  of  a  "  gamble  "  pure  and  simple,  but  that  gambling  losses 
cannot  safely  be  ignored;  (3)  where  any  material  portion  of 
the  profits  has  arisen  from  favorable  fluctuations  of  value — 
as  opposed  to  true  commercial  profits — it  is  very  desirable 
that  the  two  sources  of  profit  should  be  distinguished  in  the 
accountant's  report. 

If  there  are  any  further  items  to  the  credit  of  the  profit 
and  loss  account,  he  will  require  to  see  that  the  profit  has 
been  actually  netted,  and  that  it  is  fairly  incidental  to  the 
business  of  the  undertaking.  Even  then,  however,  a  purely 
exceptional  source  of  profit  {e.  g.,  the  fact  that  an  important 
exhibition  had  been  held  in  that  particular  industry,  or  an 
altogether  exceptional  contract  executed)  should  always  be 
specially  noted  in  the  report. 

Another  point  of  no  slight  importance  may  be  mentioned 
here,  although  it  does  not  immediately  arise  from  the  preceding 
considerations.  Where  the  undertaking  is  of  such  a  nature 
that  it  cannot  be  advantageously  carried  on  except  in  the 
present  premises,  the  accountant  should  satisfy  himself  that 
those  premises  will  be  conveyed  to  the  company  for  a  reason- 
able term.  No  sensible  man  would  buy  the  goodwill  of  a  hotel 
unless  he  could  get  a  long  lease,  if  not  the  freehold,  of  the 
hotel  premises;  while  the  goodwill  of  a  music  hall  held  on  a 
yearly  tenancy  would  not  usually  be  considered  a  good  invest- 
ment. If  the  lease  to  be  granted  to  the  company  is  at  an  in- 
creased rental,  he  must  on  no  account  forget  to  mention  the 
fact. 

Turning  now  to  the  expenses  debited  to  profit  and  loss 
account,  the  accountant  will  require  to  satisfy  himself  that 
every  legitimate  expense  has  been  actually  included.  The 
ordinary  current  expenses  present  no  especial  difficulty;  if 
the  accounts  for  the  past  three  years,  or  more,  are  available 


INVESTIGATION  ON  BEHALF  OF  PROJECTED  COMPANY.      33 1 

they  will  show  these  fairly  well,  while  a  study  of  the  accounts 
since  the  date  of  the  last  balance  sheet  will  probably  disclose 
any  outstanding  liabilities  that  have  been  improperly  omitted. 
Attention  has  already  been  called  to  the  danger  of  a  mala  fide 
ruinous  curtailment  of  expenses,  so  there  is  no  occasion  to 
again  dwell  upon  that  point. 

There  remain  now  the  questions  of  bad  debts,  repairs  and 
renewals  and  depreciation.  For  the  purpose  of  dealing  with 
these  points  the  accountant  must  refer  to  the  balance  sheets, 
as  well  as  the  profit  and  loss  accounts;  and,  inasmuch  as  he 
is  no  longer  in  the  realm  of  cut-and-dried  facts,  he  must  use 
the  greatest  amount  of  circumspection  in  arriving  at  his  ulti- 
mate opinion. 

In  dealing  with  bad  debts,  the  circumstance  that  he  is 
dealing  with  at  least  three  years'  accounts  will  help  him  to 
a  certain  extent,  for  it  will  enable  him  to  strike  an  average, 
and  he  can  compare  that  average  with  what  his  experience 
teaches  him  to  be  the  average  usually  obtaining  with  similar 
classes  of  undertakings.  Again,  the  book  debts  of  the  first 
year,  at  least,  are  almost  certain  to  be  either  collected  or  else 
written  off  before  the  end  of  the  third  year,  and  he  can  com- 
pare the  percentage  of  the  first  year's  actual  bad  debts  upon 
its  sales  with  the  percentage  written  off  each  year.  Such  a 
comparison  is  of  necessity  only  tentative,  but  it  is  useful  so 
far  as  it  goes.  Then  he  can  carefully  examine  the  last  schedule 
of  book  debts;  the  chances  are  that  he  will  know  a  very  ap- 
preciable proportion  of  the  names  there  set  down,  and  if  he 
finds  that  the  schedule  contains  names  that  some  of  his  other 
clients  look  upon  as  bad  or  doubtful,  he  must  draw  his  con- 
clusions accordingly,  to  the  best  of  his  judgment.  In  any 
case,  and  under  all  circumstances,  he  will  require  to  satisfy 
himself  that  a  sufficient  provision  for  bad  and  doubtful  debts 
has  been  debited  to  revenue. 

With  regard  to  the  question  of  depreciation,  his  position 
is,  perhaps,  a  little  more  difficult.     Speaking  generally,  if  the 


332  AUDITING. 

values  set  forth  in  the  balance  sheet  submitted  to  him  exceed 
the  amount  of  the  appraiser's  estimate,  he  may  add  such  differ- 
ence to  the  amount  of  the  depreciation  debited  to  revenue 
during  the  period  under  review.  The  method  is  not  infallible, 
however,  for  the  valuation  at  the  commencement  of  the  period 
may  have  been  too  high — in  which  case  he  will  be  charging 
an  undue  amount  against  the  profits  of  the  current  period ;  or 
it  may  have  been  too  low — in  which  case  he  will  not  have 
charged  enough.  There  are,  however,  normal  rates  of  depre- 
ciation which  may  be  used  to  verify  results,  and  previous  ex- 
perience, combined  with  sound  judgment,  will  probably  keep 
him  from  going  very  far  wrong.  Repairs  should  in  all  cases 
be  charged  up  to  revenue,  but  actual  renewals  need  not  be, 
provided  due  allowance  has  been  made  for  depreciation. 

If  part  of  the  assets  taken  over  consists  of  shares  in  other 
companies,  care  must  be  taken  to  see  that  these  are  included 
in  the  accounts  at  their  proper  value.  Where  shares  (perhaps 
unquoted  shares)  have  been  received  in  payment  of  book  debts, 
especial  attention  is  necessary,  as  the  trading  results  are  di- 
rectly affected.  Under  no  circumstances  should  revenue  be 
credited  with  more  than  normal  value  of  the  work  done  until 
the  shares  have  been  actually  sold,  and  if  the  profits  realized 
on  such  shares  form  any  appreciable  portion  of  the  total  profits 
the  accountant  should  mention  the   fact  in   his   report. 

Where  patents  form  part  of  the  proposed  purchase,  and 
where  such  patents  have  not  been  submitted  to  a  specialist  for 
valuation,  the  accountant  should  make  it  his  business  to  see — 
so  far  as  possible — that  the  inventions  purchased  are  actually 
protected.  In  a  recent  case,  a  so-called  patent  that  had  been 
purchased  by  the  original  proprietors  of  the  undertaking  in 
perfect  good  faith  was  not  really  patented  at  all. 

ADJUSTMENTS  IN  PROFITS.— For  the  purpose  of  a 
certificate  attached  to  the  prospectus  of  a  new  company  it  is 
usual  to  make  certain  adjustments  in  the  statements  of  profits 
which  would  not  ordinarily  appear  in  the  accounts  of  a  going 


INVESTIGATION  ON  BEHALF  OF  PROJECTED  COMPANY.      333 

concern.  This  arises  out  of  the  difference  between  an  investi- 
gation and  an  audit,  the  former  being  primarily  with  a  view 
to  verifying  the  revenue  account  (and  so  certifying  the  normal 
profit  of  the  undertaking),  while  the  latter  is — speaking  gen- 
erally— confined  to  a  verification  of  the  present  position  of 
affairs,  as  shown  by  the  balance  sheet.  In  order  to  avoid  any 
possibility  of  misconception,  however,  it  is  well  to  invariably 
state  what  adjustments  have  been  made  in  connection  with 
profits  which  would  not  be  usual  in  the  case  of  a  going  con- 
cern. 

These  adjustments  would,  in  all  ordinary  cases,  include  the 
amounts  paid  for  interest  on  capital,  interest  on  loans,  and 
partners'  salaries,  which  may  all  properly  be  added  to  the  net 
profits,  provided  the  fact  that  they  have  been  added  is  clearly 
stated.  There  are,  however,  other  points  which  are  possibly 
more  debatable,  and  which  will  now  be  considered. 

Depreciation. — Under  normal  circumstances  a  certification 
as  to  the  net  profits  would  naturally  assume  that  a  reasonable 
amount  had  been  written  off  such  profits  in  respect  of  the 
depreciation  of  all  assets  necessary  for  the  purpose  of  carry- 
ing on  the  business.  It  sometimes  happens,  however  (es- 
pecially where  a  large  number  of  retail  concerns  are  amalga- 
mated, for  the  purpose  of  forming  one  large  company),  that 
the  accounts  which  have  to  be  investigated  are  incomplete, 
and  that  no  reliable  information  can  be  obtained  as  to  the 
actual  value  of  the  assets  upon  which  depreciation  ought  prop- 
erly to  be  charged ;  while  it  may  be  added  that  the  normal  de- 
preciation would  naturally  to  a  large  extent  be  based  upon 
the  actual  cost  of  such  assets  to  the  present  proprietors, 
whereas  the  depreciation  which  will  have  to  be  charged  by  the 
proposed  company  in  the  future  will  of  necessity  have  to  be 
based  upon  the  amount  which  that  company  actually  pays  for 
the  assets  in  question.  Under  these  circumstances — and  under 
all  other  circumstances  where  the  same  conditions  apply — it 
is  not  merely  difficult  to  assess  the  actual  rate  of  depreciation, 
but  sometimes  actually  misleading  to  deal  with  it,  even  where 


334  AUDITING. 

it  can  be  assessed.  That  being  so,  it  is  thought  better,  where 
these  conditions  apply,  to  certify  the  amount  of  profits  which 
have  been  earned  without  any  provision  whatever  for  depre- 
ciation, leaving  the  assessment  of  the  amount  necessary  to 
provide  for  this  contingency  to  those  who  may  be  interested 
in  the  matter. 

Cash  Discounts. — Where  the  concern  in  question  has 
hitherto  been  hampered  by  want  of  capital,  and  has  therefore 
not  been  able  to  take  full  advantage  of  the  cash  discounts 
offered,  it  may  be  urged  that  it  is  permissible,  where  the  scheme 
of  the  proposed  company  provides  for  sufficient  working  capi- 
tal, to  take  credit  for  the  maximum  cash  discounts  that  might 
have  been  obtained,  had  ample  working  capital  been  employed, 
but  it  is  questionable  whether  this  is  good  practice,  as  it  is 
introducing  a  factor  which  is  largely  problematical,  as  the  dis- 
counts have  not  actually  been  realized  in  the  past  and  there  is 
no  certainty  of  their  being  actually  realized  in  the  future.  A 
supplemental  note  stating  the  estimated  amount  which  could 
have  been  obtained  had  ample  capital  been  employed  would 
be  preferable  to  including  the  figure  in  the  statement  of 
earnings. 

EXCEPTIONAL  LOSSES  AND  PROFITS.— It  has  al- 
ready been  indicated  that  the  main  object  of  any  investigation 
is  to  arrive  at  the  normal  profits  of  an  undertaking;  and,  that 
being  so,  it  is  important  that  any  exceptional  sources  of  profit 
should  be  excluded,  while  per  contra  it  is  permissible  that 
wholly  exceptional  sources  of  loss  should  be  excluded.  It  is 
very  difficult  to  define  exhaustively  either  profits  or  losses 
coming  under  this  category,  but  the  following  may  be  in- 
cluded. 

Exceptional  Losses. — Losses  not  covered  by  insurance 
arising  through  fire,  accidents  to  employees,  or  defalcations; 
provided  a  sufficient  charge  against  profits  is  made  to  cover 
the  amount  which  such  insurance  would  have  cost.  Losses 
arising  through  actions  at  law  not  altogether  incidental  to  the 
carrying  on  of  the  business,  as,  for  instance,  through  breach 


INVESTIGATION  ON  BEHALF  OF  PROJECTED  COMPANY.       335 

of  contract,  infringements  of  patents,  &c. ;  but,  if  the  losses 
arising  from  these  causes  are  excluded  it  is  essential  that  what- 
ever profits  may  have  been  earned  in  connection  with  the  sub- 
ject matter  of  the  action  should  be  also  excluded,  unless  the 
litigation  resulted  in  favor  of  -the  proprietors  of  the  business 
being  investigated. 

Under  the  heading  of  Exceptional  Profits  which  ought  to 
be  excluded  may  be  classified  all  such  transactions  as  it  is  not 
reasonable  in  the  ordinary  course  of  events  to  anticipate  will 
frequently  recur  in  the  carrying  on  of  the  existing  business 
upon  ordinary  lines.  It  is  naturally  impossible  to  deal  ex- 
haustively with  this  class  of  item,  but  the  following  headings 
may  be  mentioned: — 

(i)  Any  profit  received  from  a  municipality  or  railway,  by 
way  of  compensation  for  compulsory  removal  of  the 
business  premises. 

(2)  Any  profit  received  from  an  insurance  company  in  re- 

spect of  a  risk  covered  by  a  policy  of  insurance. 

(3)  Any  profit  received  in  connection  with  the  sale  of  a 

portion  of  the  undertaking,  as,  for  instance,  the  sale 
of  a  patent,  or  of  certain  limited  rights  to  work  a 
patent,  or  of  any  fixed  assets  that  may  have  been  ac- 
quired for  the  purpose  of  working  any  portion  of 
the  concern  in  question,  whether  that  department  may 
since  have  been  abandoned  or  not. 

Generally  in  matters  of  this  description  there  is  always  a 
temptation  to  emphasize  the  saving  which  may  be  effected  in 
the  future  by  more  skilful  management,  and  by  the  economy 
which  miglit  reasonably  be  expected  to  result  from  the  amal- 
gamation of  several  concerns.  These,  however,  are  matters 
which,  it  is  submitted,  ought  not  to  form  the  basis  of  any  ac- 
countant's certificate  as  to  profits — as  a  matter  of  fact  most 
of  the  promises  of  this  character  which  were  held  out  on  the 
flotation  of  many  large  industrial  combinations  a  few  years  ago 
have  not  been  realized,  but,  on  the  contrary,  extravagance  in 


336  AUDITING. 

management  seems  to  have  resulted  in  many  enterprises  which 
prior  to  consolidation  had  been  most  economically  adminis- 
tered. Such  certificate  should  be  rigidly  based  upon  facts,  and 
although  certain  adjustments,  as  already  indicated,  may  be 
desirable  (and  even  necessary),  so  that  a  correct  impression 
of  these  facts  may  be  gathered,  in  view  of  the  altered  condi- 
tions which  it  is  expected  will  obtain  under  a  new  company, 
under  no  circumstances  whatever  should  the  certificate  as  to 
profits  degenerate  into  anything  which  could  possibly  be  de- 
scribed as  an  estimate,  or  a  guess  of  what  may  under  certain 
circumstances  be  expected  to  happen  in  the  future. 

CONCLUSION. — By  this  time  the  accountant  will  have 
arrived  at  an  opinion  as  to  the  amount  of  profits  ordinarily 
earned  by  the  undertaking  he  is  investigating,  but  his  work 
does  not  quite  end  here.  In  practically  all  cases  an  account- 
ant pursuing  an  investigation  that  would  be  useful  would  wish 
to  analyze  the  accounts.  Not  only  is  it  thought  that  such  a 
course  is  most  desirable  as  a  safeguard  against  fraud  (where 
a  regular  and  satisfactory  audit  does  not  practically  remove 
this  contingency  from  the  sphere  of  possibilities),  but  it  is 
also  extremely  valuable  for  revealing  the  general  nature  of  the 
business  under  review. 

The  accountant  will  now  have  collected  sufficient  data  to 
enable  him  to  form  a  fairly  complete  impression  of  the  busi- 
ness which  he  has  been  investigating.  He  will  have  had  ample 
opportunity  to  study  the  general  mode  upon  which  the  business 
is  conducted,  and  he  will  have  formed  his  own  opinion  of  the 
personnel  of  the  management;  he  will  have  ascertained  the 
amount  of  capital  required  to  conduct  the  business  upon  its 
present  lines,  and  have  formed  his  own  opinion  as  to  the  scope 
it  offers  for  an  increased  capital  (if  such  a  thing  be  contem- 
plated) ;  he  will  have  ascertained  how  far  the  continued  suc- 
cess of  the  undertaking  depends  upon:  (a)  successful  competi- 
tion; (b)  the  continuance  of  a  monopoly;  and  (c)  the  caprice 
of  public  demand ;  and  have  formed  his  own  opinion  concern- 
ing their  continuance.     In  a  word,  he  will  be  able  to  gauge  the 


INVESTIGATION  UPON  THE  SALE  OF  AN  UNDERTAKING.     337 

probable  success  of  the  venture.  The  point  now  to  be  consid- 
ered is  how  far,  if  at  all,  his  personal  opinion  upon  these 
points  should  influence  his  report. 

If  it  be  conceded  that  the  object  of  the  accountant's  inves- 
tigation is  to  supply  the  place  of  an  independent  examination 
by  each  proposed  stockholder  (as  the  object  of  a  profes- 
sional audit  is  to  supersede  and  supply  the  place  of  a  personal 
examination  by  each  proprietor)  it  must  be  admitted  that  these 
opinions  are  entitled  to  some  expression.  Yet  the  expression 
of  personal  opinions  should  be  cautious  and  not  dogmatical, 
and  should  be  very  clearly  separated — where  expressed  at  all 
— from  professional  opinions  given,  as  experts,  in  matters  of 
account;  and  further,  it  should  never  degenerate  into  either 
estimates  or  prophecies.  It  is  very  difficult  to  lay  down  any 
general  rules  upon  this  point;  but,  so  long  as  the  question  is 
considered  upon  its  merits  in  each  particular  case,  the  account- 
ant will  probably  not  get  far  wrong. 

Care  must  be  taken  that  where  the  accounts  of  a  group  of 
undertakings  are  reported  upon,  and  where  they  have  been  so 
closely  allied  that  future  operations  would  require  each  prop- 
erty to  be  taken  care  of,  that  a  consolidated  balance  sheet 
and  consolidated  earnings  statement  be  submitted.  Cases 
have  been  known  where  separate  reports  have  been  made  on 
each  of  a  group  of  properties,  and  use  had  been  made  of  the 
statements  of  the  profitable  undertakings,  while  the  unprofit- 
able ones  have  been  suppressed — although  an  intending  pur- 
chaser would  have  to  operate  the  losing  as  well  as  the  profit- 
able  enterprises. 

(c)  Upon  the  Sale  of  an  Undertaking  To  a  Continuing  Part- 
ner, or  Partners,  by  a  Retiring  Partner,  or  Partners. 

There  are  several  features  connected  with  this  heading 
which  require  special  attention. 

A  "  continuing  "  partner  may  also  be  a  "  liquidating  "  part- 
ner in  cases  where  the  death  of  his  partner  was  the  moving 
cause  of  retirement,  or  the  retiring  partner  may  be  withdraw- 


338  AUDITING. 

ing  from  the  business  on  account  of  sickness,  old  age,  or  some 
other  indisposition.  In  each  of  these  contingencies  the  con- 
tinuing partner  is  charged  with  a  much  greater  limit  of  re- 
sponsibility than  the  vendee  occupies  in  any  other  position,  and 
it  is  therefore  incumbent  upon  the  auditor,  who  may  be  called 
in  to  represent  either  or  both  sides,  to  make  a  somewhat  more 
thorough  investigation  than  is  necessary  in  (a) or  (b). 

Usually  the  auditor  will  represent  the  retiring  partner  or 
his  representatives,  for  the  continuing  partner  may  be  de- 
pended upon  to  look  after  his  own  interests.  We  will,  there- 
fore, proceed  to  discuss  the  procedure  where  the  auditor  has 
been  retained  to  ascertain  the  exact  financial  condition  of  a 
concern  as  at  a  certain  date,  and  where  there  are  no  provisions 
in  the  partnership  agreement  regulating  the  basis  of  values  at 
which  the  assets  shall  be  taken. 

As  a  rule  the  accuracy  of  the  revenue  account  is  not  so 
important  as  the  balance  sheet  in  such  an  investigation,  al- 
though, of  course,  use  must  be  made  of  the  statement  of  profits 
wherever  the  value  to  be  placed  upon  goodwill  is  based 
thereon. 

Generally  speaking,  all  of  the  work  required  of  an  auditor 
who  is  investigating  for  an  intending  purchaser  will  be  re- 
quired to  be  done  for  the  seller  in  this  case,  but  we  will  now 
proceed  to  discuss  certain  further  duties.  The  valuation  of 
the  assets  should  be  upon  the  basis  of  a  going  concern,  and  it 
devolves  upon  the  auditor  to  see  that  they  are  not  under- 
valued. Obviously,  the  continuing  partner  should  on  his  own 
initiative,  even  if  the  representatives  of  the  retiring  partner 
do  not  suggest  such  action,  secure  the  services  of  independent 
appraisers,  who,  after  being  acquainted  with  the  facts,  should 
proceed  with  their  work,  having  due  regard  to  the  rights  of 
each  partner. 

In  many  cases,  however,  no  such  action  is  taken,  and  the 
surviving  or  continuing  partner  liquidates  the  business  and 
places  his  own  values  upon  the  assets.     It  is  difficult  to  lay 


INVESTIGATION  UPON  THE  SALE  OF  AN  UNDERTAKING.     339 

down  any  definite  rules  for  him  to  follow,  but  it  must  be  ob- 
served as  a  general  maxim  that  in  all  cases  where  doubt  exists 
as  to  values,  the  absent  partner  should  have  the  benefit  of  such 
doubt.  The  reason  for  this  is  clear,  for  it  must  inevitably  be 
true  that  the  continuing  partner  will  be  fully  alive  to  all  of 
the  advantages  which  according  to  his  way  of  thinking  belong 
to  him,  while  on  the  other  hand,  death  or  absence  having 
closed  the  lips  of  the  retiring  partner,  his  rights,  if  not  clearly 
set  forth,  may  escape  attention  entirely. 

It  is  a  well-known  rule  of  law  that  a  liquidating  partner 
must  not  take  the  slightest  advantage  of  his  position,  and  this 
fact  alone  would  compel  him  to  settle  all  doubts  in  favor  of 
the  absent  partner.  Probably  the  most  difficult  point  to  de- 
cide will  be  the  value  of  the  stock-in-trade,  and  as  each  case» 
of  necessity,  must  stand  on  its  merits,  no  general  rules  can  be 
laid  down. 

Nevertheless,  it  can  be  observed  that  the  ordinary  conserv- 
ative rule  of  pricing  stock  at  "market  or  cost  whichever  is 
the  lower  "  cannot  possibly  apply  here.  The  liquidating  part- 
ner is  bound  in  law  and  equity  to  realize  the  highest  possible 
price  for  anything  he  may  sell,  and  if  he  is  selling  to  him- 
self he  is  assuming  the  responsibility  of  putting  himself  in 
a  position  where  he  says  to  the  world  that  he  has  given  more 
for  the  stock  than  any  one  else  would  have  given.  In  other 
words,  he  declares  himself  to  be  the  highest  bidder.  This,  of 
course,  does  not  mean  a  bidder  at  forced  sale,  for  if  the  goods 
have  never  been  offered  to  the  public  it  is  manifestly  impos- 
sible to  put  a  forced  sale  valuation  upon  them.  The  equitable 
valuation  would  probably  be  the  cost  of  duplicating  the  entire 
stock  as  at  a  certain  date,  after  allowing,  perhaps,  for  "  dead  *' 
or  unsaleable  stock.  The  latter,  however,  is  a  dangerous  doc- 
trine, for  the  buyer  has  elected  to  take  the  business  as  it  stands, 
and  he  should  not  be  allowed  to  stipulate  that  part  of  the  stock 
is  good  and  part  bad. 

If  the  stock  consists  of  staple  goods  ascertaining  the  cost  of 
duplication  should  not  be  unduly  difficult,  and  if  the  goods  are 


340  AUDITING. 

made  to  order,  or  the  values  difficult  to  estimate,  it  would 
seem  that  the  fairest  way  to  secure  the  valuations  would  be, 
wherever  practicable,  to  trace  the  sales,  and  by  applying  the 
current  rates  of  gross  profit  thus  secure  a  basis  of  cost.  The 
accuracy  of  this  would  have  to  be  tested,  but  there  should  be 
no  difficulty  in  making  the  tests. 

If  an  agreement  were  reached  to  take  the  stock  at  cost,  it 
should  be  borne  in  mind  that  the  proper  interpretation  of  the 
word  "  cost  '*  in  this  case  would  be  the  original  price  paid  plus 
all  charges  down  to  the  date  of  inventory.  It  is  contended  by 
some  accountants  that  these  charges  include  not  only  freight, 
insurance,  storage,  handling,  rent,  &c.,  but  also  interest  down 
to  the  date  of  inventory.  The  contention  as  to  interest  is 
rather  a  nice  question  but  as  it  may  certainly  be  classed 
among  the  doubtful  items,  the  general  rule  applicable  to  this 
class  of  cases  would  seem  to  require  that  the  point  should  be 
decided  in  favor  of  the  retiring  partner. 

The  question  of  the  valuation  to  be  placed  upon  fixtures, 
Sec.,  should  be  decided  generally  upon  the  lines  laid  down 
above.  For  the  sake  of  convenience,  cost  less  proper  depre- 
ciation, would  seem  to  be  fair. 

Regarding  book  debts,  stocks,  &c.,  the  usual  custom  of 
"  working  them  out "  should  be  followed.  No  commission  or 
other  compensation  to  the  continuing  partner  can  be  allowed 
for  this,  but  the  actual  cost  of  clerical  help  is  a  proper  charge. 

Of  course,  the  retiring  partner  is  entitled  to  or  responsible 
for  his  share  of  the  profits  earned  or  losses  incurred  in  the 
carrying  out  of  contracts  executed  before  the  date  of  dissolu- 
tion or  winding  up.  Necessarily  all  of  the  expenses  of  such 
contracts  up  to  the  time  agreed  upon  have  been  charged  to 
the  business;  therefore,  it  would  be  obviously  unfair  to  the 
retiring  partner  to  have  to  pay  his  proportion  of  the  expenses 
of  making  a  sale  and  then  be  deprived  of  any  share  of  the 
profits.  This  applies  with  equal  force  to  losses;  the  continu- 
ing partner  is  not  liable  for  anything  beyond  his  own  share  of 


INVESTIGATION   UPON   THE  SALE  OF  AN   UNDERTAKING.    34I 

losses  incurred  in  executing  contracts  entered  into  in  good 
faith  prior  to  his  purchase  of  the  business. 

It  will  be  noted  from  the  above  that  all  of  the  expenses  for 
a  reasonable  period  prior  to  dissolution  should  be  carefully  ex- 
amined to  see  that  none  of  them  are  prepayments  or  apply  to 
the  subsequent  period.  As  a  matter  of  course  the  retiring  part- 
ner will  have  to  bear  his  full  proportion  of  all  liabilities,  and 
it  can  be  depended  upon  that  all  expenses  chargeable  to  the 
old  period,  no  matter  how  long  afterwards  they  be  presented, 
will  be  charged  back  where  they  belong. 

Another  point  which  will  bear  watching  is  discounts  and 
other  allowances  granted  upon  book  accounts.  It  may  happen 
that  a  customer  will  return  goods,  upon  which  claim  has  been 
made,  and  these  goods  will,  of  course,  not  be  found  in  the 
inventory.  In  ordinary  cases  they  would  be  carried  into  the 
current  stock  of  the  new  business,  and  it  is  quite  likely  that 
they  would  be  overlooked.  A  careful  analysis  of  all  credits 
to  the  old  customers,  other  than  cash,  would,  of  course,  reveal 
the  returns. 

Many  other  points,  such  as  partners'  salaries,  interest  on 
partners'  accounts  &c.,  will  require  attention,  but  it  is  believed 
that  the  above  suggestions  will  suffice  to  put  the  auditor  on 
his  guard  and  enable  him  to  sufficiently  protect  the  interests 
of  his  client. 

The  question  may  very  possibly  be  raised  that  the  account- 
ant who  pursues  the  course  here  advocated  is  not  likely  to 
enjoy  a  very  extensive  investigating  practice.  It  is  thought 
that  this  conclusion  offers  an  injustice  to  company  promoters 
as  a  class.  The  profession  of  a  company  promoter  is  a  mixed 
one,  doubtless,  but  the  black  sheep — although  naturally  the 
most  notorious — are  decidedly  in  the  minority,  and  there  are 
very  many  promoters  who  would  thoroughly  appreciate  a 
greater  strictness  in  investigations,  which  could  not  fail  to 
strengthen  the  confidence  of  the  public  in  corporate  enterprise 
as  an  advantageous  mode  of  investment. 


CHAPTER  XII. 


INTEREST. 


Every  accountant  has  in  the  course  of  his  experience  prob- 
ably had  occasion  to  note  the  lack  of  uniformity  in  the  meth- 
ods of  calculating  interest.  For  this  reason  it  has  been  thought 
well  to  insert  a  short  chapter  on  the  various  bases  of  calcula- 
tion and  the  relative  propriety  thereof. 

In  every  calculation  of  interest  there  are  three  factors, 
vis. :  principal,  rate  and  time.  With  regard  to  the  amount 
on  which  interest  is  to  be  calculated,  i.  e.,  the  principal,  no 
question  can  well  arise  as  this  amount  must  be  definitely  fixed 
beyond  the  exercise  of  any  discretion  in  the  matter  before 
a  calculation  can  be  made.  The  rate — usually,  though  by  no 
means  invariably,  expressed  on  a  per  annum  basis — is  indi- 
rectly affected  by  the  stating  of  the  time  or  period  for  which 
the  interest  is  calculated,  but  in  itself  is  really  only  capable 
of  one  application.  It  is  with  regard  to  the  third  factor  men- 
tioned— that  of  time — that  the  greatest  divergence  of  method 
is  found.  Hence,  it  is  in  order  to  note  the  different  ways  of 
stating  the  time  in  a  given  period  for  which  the  interest  is  to 
be  calculated,  with  the  related  question  of  the  unit  period  of 
time  on  which  the  calculation  is  to  be  based. 

A  question  on  which  there  has  been  much  debate  and  differ- 
ence of  opinion  and  on  which  there  is  a  divergence  in  the 
usages  of  financial  institutions  is  whether  both  the  first  and  last 
days,  or  only  one  of  them,  should  be  included  in  stating  the 
time  included  between  two  given  dates.  The  following  ex- 
tracts from  a  digest  on  the  subject  from  a  legal  standpoint  are 
of  interest  (see  49  L.  R.  A.  pp.  193-248) : 

342 


INTEREST.  343 

"  There  seems  to  be  one  general  rule  with  reference  to. 
counting  the  first  and  last  days  in  the  computation  of  a  period 
of  time  which,  subject  to  exceptions  based  upon  the  language 
of  the  provision  for  time  or  upon  the  surrounding  circum- 
stances, seems  to  have  remained  the  same  throughout  the 
whole  period  of  the  common  law,  and  which  remains  prac- 
tically the  same  under  the  statutes  and  rules  of  court.  That 
rule  is  that  in  the  computation  of  time  one  of  the  first  and  last 
days  of  the  period  shall  be  included  and  the  other  excluded. 
The  question  as  to  which  of  the  two  days  shall  be  included 
and  which  excluded,  however,  has  been  differently  decided 
in  different  periods  and  different  jurisdictions,  and  has  given 
rise  to  much  conflict  of  opinion.  The  general  common  law 
rule  as  it  originally  existed  was  that  the  first  day  was  to  be 
counted  when  the  computation  was  to  be  from  an  act  or 
event,  but  that  it  was  not  to  be  counted  when  the  reckoning 
was  to  be  from  a  day  or  from  the  day  of  an  act  or  event.  The 
more  modern  decisions  have  changed  this  rule  and  in  the  ab- 
sence of  a  statute  or  rule  of  court  controlling  the  question, 
the  courts  now  compute  time,  as  a  general  rule,  by  excluding 
the  first  day  and  including  the  last  day. 

"...  the  general  rule  now  existing,  whether  at  common 
law  or  under  the  statutes,  probably  is  that  the  first  day  of  a 
period  of  time  is  to  be  excluded  and  the  last  day  is  to  be 
included,  but  that  either  or  both  days  may  be  either  included 
or  excluded,  if  the  language  of  the  provision  for  time  is  such 
as  to  require  it,  or  if  by  so  doing  a  penalty  or  forfeiture  will 
be  avoided." 

With  particular  reference  to  negotiable  instruments: — 

"  The  general  rule  under  the  statute,  as  well  as  at  common 
law,  is  that  in  computing  the  time  that  a  note  payable  at  a 
future  day  has  to  run,  this  day  of  the  date  is  excluded. 

"  .  .  .  in  computing  the  time  when  a  note  or  bill  payable 
at  a  certain  number  of  months  after  date  will  become  due,  the 
rule  is  to  exclude  the  day  of  the  date  from  the  computatien, 


344  AUDITING. 

qnd  include  the  day  of  payment  when  no  days  of  grace  are 
allowed,  and  the  note  will  become  payable  on  the  same  day 
of  the  stipulated  month  as  that  of  its  date, 

"...  a  usage  of  banks  to  include  the  day  of  the  date,  of 
a  promissory  note  in  their  computation  of  the  time  when  it 
becomes  due  will  be  recognized  only  as  evidence  of  the  assent 
of  the  parties  to  such  usage  and  of  their  waiving  their  legal 
claims,  and  not  as  forming  rules  for  the  decision  of  the  court 
(Blanchard  v.  Hilliard;  ii  Mass.  85)." 

It  will  be  noted  that  the  foregoing  statements  as  to  nego- 
tiable paper  relate  more  directly  to  the  determination  of  the 
time  as  affecting  maturity  or  due  date  of  an  instrument  than 
to  the  time  for  which  interest  shall  be  paid  thereon.  It 
would  seem,  however,  that  the  same  rule  would  apply  to  the 
determination  of  either  question  and  that  if  a  note  is  drawn 
at  three  months  the  interest  thereon  should  be  paid  for  a 
period  of  three  months,  no  more  and  no  less. 

The  practice  among  banking  institutions  in  calculating  in- 
terest or  discount  on  loans  varies,  some  including  both  day  of 
date  and  due  date,  others  only  one  of  the  two,  while  still 
others  pursue  a  middle  course  by  including  both  days  when 
a  loan  is  first  made  but  only  one  of  the  two  days  on  renew- 
als. It  will  be  observed  that  where  the  practice  is  to  include 
both  days  it  results  in  charging  interest  twice  for  the  day  on 
which  a  renewal  note  is  given  to  take  up  the  one  maturing. 
The  argument  usually  advanced  to  justify  this  dupHcation  is 
that  the  result  would  be  the  same  if  the  borrower  were  to- 
obtain  a  loan  at  another  bank  (paying  interest  for  both  days) 
and  use  the  proceeds  to  pay  the  maturing  note. 

Several  cases  bearing  on  these  points  which  came  before 
the  courts  many  years  ago  merit  consideration,  though  it  will 
be  noticed  that  the  decisions  are  directly  opposed  to  each  other. 

In  1829  the  Supreme  Court  of  Vermont  heard  the  case  of 
Bank  of  Burlington  v.  Durkee  (i  Vt.  399),  in  which  the  cir- 
cumstances were  as  follows: 


INTEREST.  345 

A  note  for  $2,000  payable  64  days  from  date  had  been  dis- 
counted by  the  bank,  the  interest  charged  thereon  being  64 
days  on  the  basis  of  360  days  to  the  year,  $21.33.  The  de- 
fendant claimed  that  as  the  interest  at  6  per  cent,  (the  highest 
rate  permitted  by  the  law  of  the  state)  on  a  365 -day  basis 
would  only  amount  to  $21.04,  and  there  being  no  statute 
legalizing  the  360-day  basis,  the  bank  had  taken  usury  amount- 
ing to  29  cents.  The  contention  of  counsel  for  the  bank  in 
attempting  to  refute  the  charge  of  usury  introduced  into  the 
case  the  question  of  the  right  to  charge  for  both  the  first  and 
last  days  of  the  period,  stating  that: 

"The  discount  received  by  the  bank  was  $21.33,  being  the  interest 
on  $2,000  for  64  days  at  the  rate  of  6  per  cent,  for  360  days.  Now, 
inasmuch  as  the  borrower  received  the  money  on  the  day  of  the  dis- 
count, and  was  not  liable  to  pay  the  same  until  he  had  the  use  of  it 
for  65  days,  including  the  day  of  discount,  the  bank  had  a  right  by 
law  to  take  interest  at  the  rate  of  6  per  cent,  per  annum  for  65  days, 
which  would  in  fact  exceed  the  interest  taken  by  4  cents." 

The  court,  however,  ruled  that  it  was  unlawful  to  charge 
interest  for  both  the  day  of  discount  and  the  day  of  matur- 
ity, stating  that: 

"The  mode  of  computing  interest  in  a  case  like  the  present  is:  Ex- 
clude the  day  on  which  the  note  is  discounted  and  on  which  it  ought 
for  this  purpose,  if  not  every  other,  be  considered  as  delivered.  It 
being  discounted  on  the  i6th,  any  time  on  the  17th,  without  regarding 
the  fractions  of  that  day,  there  would  be  one  day's  interest;  and  so  on 
through  the  whole  64  days.  By  this  mode  of  computation,  the  bank 
took  as  interest  upon  $2,000  for  64  days,  29  cents  too  much;  that  is 
almost,  but  not  quite,  one  day's  interest  upon  the  sum  of  the  note. 

" .  .  .  .  The  taking  of  the  29  cents,  as  above  mentioned,  is  the 
taking  of  more  than  the  6  per  cent,  allowed  by  the  statute." 

In  the  case  decided  in  the  Virginia  Court  of  Appeals  in 
1834  (Crump  V.  Nicholas  5  Leigh  251)  the  opposite  opinion 
was  expressed.     The  circumstances  were  as  follows: 

The  Farmers'  Bank  of  Virginia  discounted  a  note  for  $6,000, 
payable  on  its  face  60  days  after  date,  it  being  understood  that 


346  AUDITING. 

the  loan  would  be  renewed  indefinitely  till  it  should  suit  the 
interest  or  convenience  of  either  the  bank  or  the  borrower  to 
terminate  the  arrangement.  In  point  of  fact  the  loan  was 
continued  on  renewal  notes  from  21st  April,  1825,  to  4th  May, 
1826.  In  discounting  the  first  note,  the  bank  deducted  inter- 
est for  64  days,  i.  e.,  counting  from  the  day  of  date  to  the  last 
day  of  grace,  both  inclusive,  and  in  discounting  the  second 
note,  made  on  the  last  day  of  grace  of  the  first,  likewise  de- 
ducted interest  for  64  days,  counting  from  the  day  of  date  of 
the  second  and  last  day  of  grace  of  the  first,  to  the  last  day  of 
grace  of  the  second  note,  both  inclusive ;  and  so  on  upon  each 
renewal  note  successively  to  the  end  of  the  transaction.  Thus 
the  bank  received  double  interest  for  every  64th  day.  This 
was  in  conformity  with  the  known  usage  of  the  Farmers'  Bank 
and  of  all  the  banks  of  Virginia. 

It  was  held  that  the  transaction  was  in  nowise  usurious. 
The  unanimous  opinion  of  all  the  judges  was  that  the  charge 
of  interest  for  both  the  first  and  last  days  on  the  first  note  was 
lawful,  as  a  borrower,  when  making  a  loan,  may  receive  and 
have  the  use  of  the  money  borrowed  early  in  the  morning  of 
the  first  day,  and  is  not  bound  to  pay  until  the  last  moment 
of  the  bank  day  when  due,  and  hence,  the  law  knowing  no  frac- 
tion of  a  day,  has  the  use  of  the  money  both  days,  but  a  dissent- 
ing opinion  was  filed  as  to  the  legality  of  charging  double  inter- 
est for  the  days  on  which  the  renewal  notes  were  given.  Four 
judges  held  that  as  there  was  no  binding  agreement  to  renew 
the  loan,  each  discount  was  a  separate  and  distinct  transaction, 
and  the  same  treatment  of  the  renewals  as  of  original  note  was 
permissible.  The  dissenting  judge  raised  no  question  as  to  the 
propriety  of  charging  double  interest  for  the  renewal  date  per 
se,  but  claimed  that  on  the  day  of  each  renewal  the  previous 
intention  or  expectation  to  renew  was  carried  into  effect  and 
became  an  agreement  between  the  parties  on  that  date  and  the 
discount  and  the  appropriation  and  application  of  the  proceeds 
of  the  new  note  to  the  payment  of  the  maturing  note,  by  con- 
sent of  both  parties,  were  evidence  of  the  agreement  and  con- 


INTEREST.  347 

sequently  all  the  notes  excepting  the  first  were  tainted  with 
usury. 

"  When  judges  disagree  who  shall  decide?  "  Before  attempt- 
ing to  say  what  rule  would  be  most  equitable  to  follow — since 
from  the  foregoing  decisions  it  seems  to  depend  upon  what 
part  of  the  country  one  is  in  as  to  what  rule  would  be  lawful — 
it  would  be  well  to  consider  the  question  from  another  side, 
banking  institutions,  which  are  usually  the  lenders  who  charge 
interest  for  both  first  and  last  days,  do  not  allow  interest  on 
deposits  on  the  same  basis,  hence  why  pursue  an  opposite 
course  with  regard  to  interest  charged  on  loans  ?  As  the  officer 
of  a  large  trust  company  expressed  it :  "  We  allow  interest  on 
the  basis  which  requires  us  to  pay  out  the  least  money,"  and 
had  he  gone  on  to  refer  to  the  basis  of  charging  interest  on 
loans  he  would  doubtless  have  stated  quite  as  frankly  that  *  we 
charge  interest  on  the  basis  which  brings  us  in  the  most 
money."     Such  a  course,  however,  is  certainly  not  equitable. 

On  the  whole  the  fairest  rule  would  seem  to  be  that  laid 
down  in  the  paragraphs  quoted  in  the  earlier  part  of  this  chap- 
ter, viz.,  to  exclude  either  the  first  or  last  day  from  the  period 
of  time  for  which  a  calculation  is  being  made.  In  Kirkbride 
and  Sterrett's  "  The  Modern  Trust  Company  "  (page  84),  the 
rule  is  stated  thus :  "In  computing  interest  on  loans,  the  actual 
number  of  days  is  taken.  If  the  day  on  which  the  loan  was 
made  is  included,  the  day  of  payment  is  not  counted." 

Because  of  the  lack  of  uniformity  among  financial  institu- 
tions with  regard  to  interest  and  discount  on  loans  this  has 
been  made  more  particularly  the  subject  of  review  in  the  fore- 
going paragraphs,  but  the  principle  is  the  same  in  any  business 
or  in  any  transaction  involving  interest.  Interest  on  book  ac- 
counts would  naturally  be  calculated  on  the  same  principles  as 
negotiable  instruments.  In  commercial  houses  the  custom  is 
to  include  either  the  first  or  last  day,  not  both,  in  making 
interest  calculations. 


34^  AUDITING. 

Among  stock  brokers  there  is  also  some  lack  of  uniformity 
in  charging  interest  on  customer's  accounts.  The  purchases  of 
one  day  are  settled  for  the  following  day,  which  is  when  the 
customer's  account  is  debited,  and  by  some  brokers  both  this 
day  and  the  last  day  of  the  month  are  included  in  calculating 
the  interest  charge  for  the  month  in  which  the  purchase  is 
made.  For  the  reasons  already  stated,  however,  the  charge 
should  only  take  into  account  one  or  the  other  of  the  two  days 
in  question,  though  it  should  be  said  in  favor  of  the  broker 
that  as  long  as  he  is  compelled  to  pay  interest  on  his  loans 
payable  on  the  basis  of  including  both  days  in  the  calculation,, 
he  would  seem  to  be  entitled  to  charge  his  customers  interest 
on  a  like  basis. 

A  practice  on  the  part  of  some  trust  companies  of  crediting 
interest  on  deposits  only  from  the  day  following  the  deposit 
is  injecting  the  factor  of  exchange  into  the  question;  the  rea- 
son for  the  practice  is  to  allow  the  trust  company  one  day  in 
which  to  make  collection  of  the  checks  which  form  the  bulk 
of  most  deposits.  In  the  case  of  large  deposits  consisting  of 
items  drawn  on  distant  points  the  credit  of  interest  might,  of 
course,  be  suspended  for  a  longer  period  than  one  day. 

The  second  question  relating  to  the  factor  of  time  is,  as  has 
already  been  mentioned,  the  unit  period  on  which  the  calcula- 
tion is  based.  Interest  rates  are  usually  stated  on  an  annual 
basis,  i.  e.,  they  are  expressed  as  a  percentage  of  the  principal 
which  is  to  be  added  thereto  for  the  use  thereof  for  one  year. 
Even  when  the  rate  is  not  stated  as  so  much  "  per  annum  "  it 
is,  unless  expressly  stated  otherwise,  usually  so  understood. 

Payments  of  interest  made  periodically  in  pursuance  of  an 
agreement  do  not  as  a  rule  raise  any  question  concerning  their 
calculation.  If  monthly,  quarterly  or  semi-annual  payments 
they  are  simply  one-twelfth,  one-fourth  or  one-half  of  the  in- 
terest for  a  full  year. 

In  the  case  of  interest  for  fractional  or  odd  periods  of  time 
varying  methods  of  calculation  are  again  encountered.     Theo- 


INTEREST.  349 

retically  the  correct  method  would  be  to  ascertain  the  number 
of  days  and  take  this  number  of  365th  of  a  full  year's  interest. 
Some  banking  institutions  use  this  method,  though  by  far  the 
greater  number  base  their  calculations  on  a  year  of  360  days. 
The  latter  method  is  the  most  convenient  when  interest  tables 
are  not  used,  but  when  tables  are  used  one  method  is  just  as 
simple  as  the  other. 

In  1824  the  Supreme  Court  of  New  York  ruled  that  the 
taking  of  interest  on  the  basis  of  360  days  to  the  year  was 
usurious.  (AT.  Y.  Firemen  Ins.  Co.  v.  Ely  2  Cowen  705).  In 
the  case  of  Bank  of  Burlington  v.  Durkee,  to  which  reference 
has  already  been  made  (vide  page  344),  the  Supreme  Court  of 
Vermont  stated  that  it  was  not  prepared  to  go  to  the  same 
length  to  which  the  New  York  Supreme  Court  had  gone,  and 
said : 

"  If  a  bank  commences  and  carries  on  its  operations  in  a 
way  pursued  by  all  the  banks  in  the  country,  and  the  way  that 
has  been  pursued  by  them  for  30  years,  and  even  from  the 
£rst  establishment  of  banks  in  this  country,  and  uses  the  same 
tables  for  casting  interest;  or,  to  speak  more  properly,  takes 
the  interest  from  those  tables  already  cast,  for  any  sum  and 
any  term,  those  same  being  printed  tables  and  kept  for  the 
accommodation  of  banks  and  business  men;  and  during  all 
this  time  the  mode  of  casting  and  taking  interest  has  been 
acquiesced  in  as  correct  and  no  resistance  made  to  it  in  any  of 
the  numerous  actions  in  which  the  defence  might  be  made,  if 
good  in  any  case — under  all  these  circumstances,  it  cannot  be 
presumed  that  the  bank  acted  with  any  intention  to  oppose  or 
violate  the  statute.  In  such  a  case  the  bank  would  have  reason 
"to  believe  that  the  statutes  of  usury  had  received  a  construc- 
tion from  the  bench  that  sanctioned  this  mode  of  casting  inter- 
est, or  at  least  that  it  received  the  universal  approbation  of 
mankind.  The  going  in  a  path  so  well  understood,  so  long  in 
use  and  in  such  general  use,  precludes  all  presumption  of  any 
intention  to  evade  the  statute  or  do  any  wrong  whatever." 


350  AUDITING. 

The  court  accordingly  held  that  while  the  bank  might  have 
taken  usury  tlie  transaction  was  made  in  good  faith,  in  pur- 
suance of  long  established  usage  and  with  no  intent  to  disobey 
the  law,  and  the  court  declined  to  inflict  the  extreme  penalty  of 
usury,  but  merely  stated  that  the  bank's  claim  ought  to  be 
reduced  by  29  cents. 

In  a  case  decided  in  the  Virginia  Court  of  Appeals  in  1837 
(State  Bank  of  North  Carolina  v.  Cowan,  etc.  8  Leigh  238) 
the  claim  was  made  that  discounts  of  notes  at  6  per  cent.,  based 
on  360  days  to  the  year  instead  of  365  were  usurious.  The 
court,  however,  held  otherwise. 

Many  states  have  by  statute  legalized  this  banking  usage, 
in  others  it  is  permitted  or  obtains  merely  by  force  of  custom. 
In  the  revision  of  the  statutes  of  New  York  in  1892  the 
statute  legalizing  the  360-day  basis  of  interest  was  dropped  and 
at  present  time  this  method  of  calculating  interest,  when  the 
maximum  rate  is  charged,  is  technically  illegal  in  that  state. 

Under  an  act  passed  at  the  1909  session  of  the  Massachu- 
setts legislature  and  approved  on  March  6,  1909,  interest  on  all 
loans  of  money  and  on  all  bonds  and  notes  purchased  or  held 
by  the  Commonwealth  will  hereafter  be  computed  on  the  basis 
of  365  days  to  the  year  instead  of  360  days.  The  law  is  known 
as  Chapter  148  of  the  Acts  of  1909  and  reads  as  follows : 

An  Act  Relative  to  the  Computation  of  Interest  on  Bonds  and 
Notes  in  Dealings  with  the  Commonwealth. 

Be  it  enacted,  &c.,  as  follows: 

Section  i.  On  all  loans  of  money  made  to  or  by  the  Com- 
monwealth and  on  all  bonds  and  notes  purchased  or  held  by 
the  Commonwealth,  interest  shall  be  computed  on  the  basis  of 
three  hundred  and  sixty-five  days  to  the  year  and  not  on  the 
basis  of  three  hundred  and  sixty  days  to  the  year. 

In  calculating  interest  for  a  part  of  the  period  for  which  it 
may  regularly  be  paid,  say  quarterly  or  semi-annually,  as  on 


INTEREST.  351 

bonds  or  mortgages,  it  is  probably  more  general  to  state  the 
time  in  months  and  days  than  entirely  in  days.  In  such  a  case 
the  number  of  full  months  from  the  date  to  the  same  num- 
bered day  next  preceding  the  final  date  should  first  be  deter- 
mined and  then  the  odd  days  to  the  final  date. 

The  months,  irrespective  of  whether  they  have  30  or  31 
days,  would  be  treated  as  so  many  twelfths  of  a  year,  but  as  to 
the  odd  days  there  is  again  a  variation  in  treatment,  sometimes 
being  taken  as  so  many  30th  of  a  month  (equivalent  to  a  360- 
day  basis),  and  sometimes  being  figured  as  so  many  28th,  30th 
or  3ists,  according  to  the  month  in  which  they  occur.  With 
the  latter  method  difficulty  arises  if  part  of  the  odd  days  are  in 
a  month  having  30  days  and  part  in  one  having  31  days,  e.  g., 
from  23rd  April  to  15th  May  would  be  22  days,  but  shall 
they  be  considered  30th  or  3ists  of  a  month?  Either  way  of 
treating  them  would  be  to  a  certain  extent  arbitrary.  Still 
another  method  of  dealing  with  the  odd  days  would  be  to  con- 
sider them  as  365th  of  a  year.  Either  the  first  or  the  last 
method  would  seem  to  be  preferable,  the  first  (treating  them 
as  30ths)  having  the  merit  of  consistency,  as  it  brings  the 
treatment  of  the  full  months  and  the  odd  days  more  nearly  on 
the  same  basis,  though  the  last  is  doubtless  more  strictly  in 
accord  with  the  law  in  those  states  which  have  no  statute  legal- 
izing the  360-day  basis. 

The  auditor  who  has  occasion  to  verify  interest  calculations 
will  naturally  first  acquaint  himself  with  any  special  condi- 
tions or  circumstances  which  may  obtain.  E.  g.,  savings  banks 
frequently  have  rules  concerning  the  interest  to  be  allowed  on 
deposits  which  provide  for  certain  concessions  or  the  reverse. 
'Deposits  made  on  any  day  between  the  first  and  fifth  may  be 
permitted  to  draw  interest  from  the  first  of  the  month,  while 
deposits  after  the  fifth  may  not  draw  interest  until  the  follow- 
ing month.  In  some  cities  where  the  savings  banks  and  trust 
companies  allow  a  rate  of  interest  on  time  deposits  which  is 
higher  than  obtains  in  many  other  cities,  they  have  rules  con- 
cerning the  calculation  of  interest  which  result  in  reducing 


352  AUDITING. 

materially  the  average  rate  actually  paid  on  deposits.     These 
rules  in  one  large  city  are : 

That  deposits  from  the  2d  to  the  15th  of  the  month 
draw  interest  only  from  the  15  of  the  month;  deposits 
from  the  i6th  to  the  ist  of  the  following  month  draw 
interest  only  from  the  latter  date. 

Withdrawals  during  any  semi-annual  interest  period 
lose  all  interest  accrued  thereon  since  the  last  interest  date. 

The  first  rule  is  not  any  more  severe  than  the  rules  usually 
-obtaining,  as  it  is  quite  a  general  custom  to  allow  interest  on 
savings  deposits  only  by  full  calendar  months.  The  latter 
rule,  however,  is  the  one  which  accomplishes  the  greatest  re- 
duction in  the  rate  of  interest  actually  paid.  A  large  sum  of 
money  withdrawn  after  having  been  on  deposit  for,  say  five 
months  since  the  last  interest  date,  receives  no  interest  what- 
ever for  that  period. 

It  may  be  of  interest  to  note  the  rules  for  calculating  interest 
which  obtain  in  the  Treasury  Department  of  the  Government. 
The  following  is  the  substance  of  information  furnished  by  the 
Government  Actuary: 

Only  one  of  the  two  days  of  date  and  due  date  of  an  obligation  is 
taken  into  account  in  stating  the  time  for  which  interest  is  to  be 
calculated. 

When  interest  is  payable  semi-annually  or  quarterly,  half  or  one- 
quarter  of  a  full  year's  interest  is  apportioned  to  each  period. 

In  calculating  interest  for  a  fractional  period,  the  time  is  the  true 
fraction  of  that  period.  For  an  annual  rate,  the  time  is  the  exact 
number  of  days  for  which  the  interest  runs  divided  by  the  number  of 
days  in  the  year,  365  or  366;  for  a  semi-annual  or  quarterly  period,  it 
is  the  number  of  days  for  which  interest  runs  divided  by  the  number 
of  days  in  that  particular  half  year  or  quarter  year. 

Unless  the  unit  period  is  a  month  the  month  does  not  enter  into 
interest  computations;  only  days  and  the  full  unit  period  being 
considered. 

A  few  words  on  discount  and  usury,  which  are  closely  re- 
lated to,  or  rather  form  a  part  of,  the  general  subject  of  inter- 


INTEREST.  353 

est,  are  in  order.  Any  one  who  gives  the  matter  any  consid- 
eration can  readily  see  that  to  collect  interest  in  advance  or  to 
"  discount,"  results  in  a  rate  of  interest,  when  calculated  on  the 
amount  actually  received  by  the  borrower,  higher  than  the 
nominal  rate.  When  the  nominal  rate  of  the  discount  is  the 
highest  rate  of  interest  permitted  by  law — and  a  large  majority 
of  the  states  have  fixed  the  maximum  rate  which  may  be 
charged — technically  it  becomes  a  usurious  transaction.  The 
following  extracts  from  a  review  of  the  legal  status  of  the 
practice  indicate  that  the  courts  generally  have  held  that  unless 
used  to  excess  it  will  be  permitted  (29  L.  R.  A.  761-8). 

"In  general,  it  must  be  regarded  as  well  established  that,  at  least 
on  short-time  paper,  interest  may  be  taken  by  way  of  discount  in 
advance,  and  at  the  highest  rate  allowed  by  law,  although  this  does 
in  reality  make  the  interest  paid,  if  computed  on  the  amount  actually 
received  for  use  by  the  borrower,  exceed  the  legal  rate  by  the  amount 
of  the  interest  upon  the  interest  for  the  time  of  the  debt 

"  The  right  to  take  interest  in  advance  is  expressly  given  to  national 
banks  by  U.  S.  Rev.  Stat.,  §5197,  which  fixes  the  rate  at  7  per  cent, 
in  cases  where  no  rate  is  fixed  by  the  laws  of  the  state,  territory  or 
district  where  the  bank  is  located,  but  providing  that  such  banks  shall 
not  take  greater  interest  than  the  local  laws  permit;  except  where 
such  laws  fix  a  different  rate  for  the  state  banks  of  issue,  and  then 
such  rate  is  allowed  to  the  national  banks. 

(There  have  been  decisions  in  which  discount  or  interest  taken  in 
advance  for  a  period  of  one  year  or  even  longer  have  been  held  to  be 
not  usurious.) 

"  A  note  for  $8,880,  payable  one  year  from  date,  given  in  renewal 
of  a  note  for  $8,000,  was  held  usurious  under  a  statute  authorizing  10 
per  cent,  interest,  although  interest  could  be  lawfully  taken  in  ad- 
vance (First  National  Bank  v.  Davis,  108  111.,  633).  Two  judges  dis- 
sented from  this  decision  on  the  ground  that  the  amount  of  the  note 
was  no  more  than  might  have  been  realized  from  lawful  interest  had 
the  interest  for  one  year  been  paid  in  advance 

"  Nearly  all  cases  have  upheld  payments  of  interest  in  advance  when 
interest  was  paid  periodically." 

The  laws  of  New  York  expressly  provide  that  a  bank  or 
banker  may  deduct  interest  in  advance,  as  will  be  noted  in  the 
following : 


354  AUDITING. 

Section  74  of  the  Banking  Law,  as  contained  in  the  Consoli- 
dated Laws  of  the  State  of  New  York,  enacted  in  1909  (being 
Chap.  10  of  the  Laws  of  1909  and  Chap.  2  of  the  ConsoHdated 
Laws  of  that  year  in  Article  III  thereof)  is  as  follows: 

"RATE  OF  INTEREST.  Every  bank  and  private  and 
individual  banker  doing  business  in  this  state  may  take, 
receive,  reserve  and  charge  on  every  loan  and  discount  made, 
or  upon  any  note,  bill  of  exchange  or  other  evidence  of  debt, 
interest  at  the  rate  of  six  per  centum  per  annum;  and  such 
interest  may  be  taken  in  advance,  reckoning  the  days  for  which 
the  note,  bill  or  evidence  of  debt  has  to  run. 

"  The  knowingly  taking,  receiving,  reserving  or  charging  a 
greater  rate  of  interest  shall  be  held  and  adjudged  a  forfeiture 
of  the  entire  interest  which  the  note,  bill  of  exchange  or  other 
evidence  of  debt  carries  with  it,  or  which  has  been  agreed  to 
be  paid  thereon.  If  a  greater  rate  of  interest  has  been  paid, 
the  person  paying  the  same,  or  his  legal  representatives,  may 
recover  twice  the  amount  of  the  interest  thus  paid  from  the 
bank  or  private  or  individual  banker  taking  or  receiving  the 
same,  if  such  action  is  brought  within  two  years  from  the  time 
the  excess  of  interest  is  taken.  The  purchase,  discount  or  sale 
of  a  bona  fide  bill  of  exchange,  note  or  other  evidence  of  debt 
payable  at  another  place  than  the  place  of  such  purchase,  dis- 
count or  sale  at  not  more  than  the  current  rate  of  exchange  for 
sight  draft,  or  a  reasonable  charge  for  the  collection  of  the 
same,  in  addition  to  the  interest,  shall  not  be  considered  as 
taking  or  receiving  a  greater  rate  of  interest  than  six  per 
centum  per  annum. 

The  true  intent  and  meaning  of  this  section  is  to  place  and 
continue  banks  and  private  and  individual  bankers  on  an  equal- 
ity in  the  particulars  herein  referred  to,  with  the  national  banks 
organized  under  the  Act  of  Congress  entitled,  '  An  act  to  pro- 
vide a  national  currency  secured  by  pledges  of  United  States 
bonds,  and  to  provide   for  the  circulation  and   redemption, 


INTEREST.  355 

thereof/  approved  June  third,  eighteen  hundred  and  sixty- 
four/' 

In  conclusion,  the  following  rules  on  points  concerning 
which  there  is  a  variation  in  practice,  might  be  formulated 
as  being  the  most  accurate,  and  most  equitable  to  both  the 
payor  and  payee  of  interest. 

1.  In  stating  the  time  between  two  dates,  include  only 
one  of  the  two  days,  not  both. 

2.  For  interest  payable  at  regular  intervals,  as  semi- 
annually, quarterly  or  monthly,  such  periods  should  be 
considered  as  one-half,  one-quarter  or  one-twelfth,  re- 
spectively, of  the  year. 

3.  For  a  fraction  of  any  of  the  foregoing  periods  the 
time  should  be  stated  in  months  and  days,  each  month 
being  considered  one-twelfth  of  a  year,  and  the  odd  days 
as  30ths  of  a  month. 

4.  When  interest  is  calculated  for  the  actual  number 
of  days  in  a  period,  it  should  be  on  the  basis  of  365  days 
to  the  year. 

5.  The  foregoing  rule  may  be  modified  where  a  definite 
and  well  understood  custom  exists  of  charging  and  paying 
on  the  basis  of  360  days  to  the  year,  but  the  custom 
should  be  known  to  both  parties. 


APPENDIX  A. 


Summary  of  the  Rules  laid  down  by  the  Courts 
with  respect  to,  and  Reports  of  Cases  dealing 
with,  the  Rights  and  Liabilities  of  Auditors. 


So  far  as  we  are  aware,  no  reported  case  in  America  has 
yet  dealt  with  the  liabiHty  of  professional  auditors.  We  are. 
therefore,  compelled  to  resort  to  the  English  decisions,  from 
which  we  deduce  the  following  legal  rules: — 

It  will  be  observed  that  the  courts  have  laid  down  rules 
of  liability  which  are  by  no  means  onerous;  and  indeed  it 
would  seem  that  the  practice  which  we  have  advocated  in  the 
preceding  pages  of  this  book  is  considerably  stricter  than  the 
courts  require.  However,  it  is  always  well  to  be  on  the  safe 
side,  and  an  auditor  can  have  the  satisfaction  of  knowing 
that  if  he  follows  the  practice  which  we  have  heretofore  laid 
down,  he  will  be  amply  on  the  safe  side  of  the  law. 

Remembering  then  that  the  following  are  simple  rules  of 
legal  liability  laid  down  by  the  courts,  and  not  rules  of  prac- 
tice which  the  authors  would  in  all  cases  advocate,  we  sum- 
marize the  English  decisions  as  follows : 

1.  An  auditor  must  do  more  than  ascertain  the  arithmetical 
accuracy  of  the  balances.  He  must  see  that  the  books  give 
a  true  and  accurate  representation  of  his  clients'  financial 
affairs. 

2.  In  doing  this,  the  auditor  is  not  an  absolute  insurer  of 
the  accuracy  or  truthfulness  of  the  books.  He  is  bound  only 
to  use  reasonable  care,  the  care  of  an  ordinarily  skilful  audi- 
tor under  the  particular  circumstances. 

356 


APPENDIX  A.  357 

3.  What  is  reasonable  care  in  any  given  case  must  depend 
upon  the  circumstances  of  that  case.  Where  there  is  nothing 
to  excite  suspicion,  very  little  inquiry  may  be  sufficient.  It 
is  legally  sufficient  for  the  auditor  to  select  a  few  cases  hap- 
hazard, see  that  they  are  right,  and  assume  that  others  like 
them  are  correct  also;  check  the  cash,  examine  vouchers  for 
payments,  see  that  the  bills  and  securities  entered  in  the  books 
are  correct,  and  take  reasonable  care  to  ascertain  their  value. 
He  is  not  bound  to  take  stock;  he  should,  however,  satisfy 
himself  as  to  its  accuracy  so  far  as  he  can.  As  to  the  other 
assets  and  liabilities  he  must  use  reasonable  diligence  in  veri- 
fying them  before  certifying  to  the  correctness  of  the  balance 
sheet. 

4.  Until  the  contrary  is  suggested  by  circumstances  of  ob- 
vious suspicion  appearing  on  the  books  themselves,  the  auditor 
is  justified  in  assuming  that  the  clients'  clerks,  bookkeepers, 
officers  et  al.  are  honest. 

5.  Unless  some  suspicious  circumstance  exists,  the  auditor 
is  not  legally  bound  to  communicate  with  third  parties  (cus- 
tomers or  creditors)  to  see  if  their  accounts  are  accurately 
stated  in  the  books.  Unless  he  has  been  elected  by  the  stock- 
holders, he  probably  has  no  right  to  report  to  them  directly 
at  all. 

6.  An  auditor's  report  must  plainly  point  to  the  client  any 
unsatisfactory  features  of  the  account.  The  auditor  does  not 
discharge  this  duty  by  simply  giving  the  client  so  much  infor- 
mation as  is  calculated  to  induce  the  client  to  ask  for  more. 
The  auditor  must  convey  information,  not  merely  arouse 
inquiry. 

The  following  extracts  from  the  cases  are  instructive.  As 
heretofore  mentioned,  these  cases  are  reported  in  greater  de- 
tail in  the  Seventh  English  Edition  of  this  work,  and  reference 
thereto  should  be  had  if  additional  information  is  desired. 


358  AUDITING. 

Leeds  Estate  Building  CSi,    Investment    Society,    Lim.,  v. 
Shephard,  L.  R.  36  Ch.  Div.  787  (August  9,  1887.) 

Dividends  had  been  paid  out  of  capital  and  the  auditor  had 
passed  the  account. 

Held:  That  it  is  the  auditor's  duty  not  to  confine  himself 
merely  to  the  task  of  ascertaining  the  arithmetical  accuracy 
of  the  balance  sheet,  but  to  see  that  it  is  a  true  and  accurate 
representation  of  the  company's  affairs. 

In  examining  the  balance  sheets  the  auditor  was  not  fur- 
nished with  a  copy  of  the  articles  of  incorp>oration,  and  he 
did  not  comply  with  their  provisions.  Held:  That  it  was  no 
excuse  that  the  auditor  had  not  seen  the  articles  when  he  knew 
of  their  existence. 

In  Re  London  CBb  General  Bank,  1895,  2  Ch.  Div.  673. 

An  auditor  is  guilty  of  misfeasance  who,  when  dissatisfied 
with  the  accounts  of  a  company,  does  not  plainly  draw  atten- 
tion to  the  grounds  of  his  dissatisfaction  in  his  certificate. 

The  court  discusses  the  matter  at  length  as  follows: — 

"  It  is  not  part  of  an  auditor's  duty  to  give  advice  either 
to  directors  or  shareholders  as  to  what  they  ought  to  do.  An 
auditor  has  nothing  to  do  with  the  prudence  or  imprudence 
of  making  loans  with  or  without  security.  It  is  nothing  to 
him  whether  the  business  of  a  company  is  being  conducted 
prudently  or  imprudently,  profitably  or  unprofitably;  it  is 
nothing  to  him  whether  dividends  are  properly  or  improperly 
declared,  provided  he  discharges  his  own  duty  to  the  share- 
holders. His  business  is  to  ascertain  and  state  the  true  finan- 
cial position  of  the  company  at  the  time  of  the  audit,  and  his. 
duty  is  confined  to  that.  But  then  comes  the  question :  How 
is  he  to  ascertain  such  position?  The  answer  is:  By  ex- 
amining the  books  of  the  company.  But  he  does  not  discharge 
his  duty  by  doing  this  without  inquiry  and  without  taking  any 


APPENDIX  A.  359 

trouble  to  see  that  the  books  of  the  company  themselves  show 
the  company's  true  position.  He  must  take  reasonable  care 
to  ascertain  that  they  do.  Unless  he  does  this,  his  duty  will 
be  worse  than  a  farce.  Assuming  the  books  to  be  so  kept  as 
to  show  the  true  position  of  the  company,  the  auditor  has  to 
frame  a  balance  sheet  showing  that  position  according  to  the 
books,  and  to  certify  that  the  balance  sheet  presented  is  cor- 
rect in  that  sense.  But  his  first  duty  is  to  examine  the  hooks, 
not  merely  for  the  purpose  of  ascertaining  what  they  do  shozv, 
but  also  for  the  purpose  of  satisfying  himself  that  they  show 
the  true  financial  position  of  the  company.  This  is  quite  in 
accordance  with  the  decision  of  Mr.  Justice  Stirling  in  The 
Leeds'  Estate  Company  v.  Shephard,  in  36  Chancery  Division, 
page  802.  An  auditor,  however,  is  not  bound  to  do  more  than 
exercise  reasonable  care  and  skill  in  making  inquiries  and  in- 
vestigations. He  is  not  an  insurer ;  he  does  not  guarantee  that 
the  books  do  correctly  show  the  true  position  of  the  company's 
affairs;  he  does  not  guarantee  that  his  balance  sheet  is  ac- 
curate according  to  the  books  of  the  company.  If  he  did  he 
would  be  responsible  for  an  error  on  his  part,  even  if  he  were 
himself  deceived,  without  any  want  of  reasonable  care  on  his 
part — say  by  the  fraudulent  concealment  of  a  book  from  him. 
His  obligation  is  not  so  onerous  as  this. 

"  Such  I  take  to  be  the  duty  of  the  auditor ;  he  must  b^ 
honest— that  is,  he  must  not  certify  what  he  does  not  believe 
to  be  true,  and  he  must  take  reasonable  care  and  skill  before 
he  believes  that  what  he  certifies  is  true. 

"  What  is  reasonable  care  in  any  particular  case  must  de- 
pend upon  the  circumstances  of  that  case.  Where  there  is 
nothing  to  excite  suspicion,  very  little  inquiry  will  be  reason- 
able and  sufficient;  and  in  practice,  I  believe,  business  men 
select  a  few  cases  haphazard,  see  that  they  are  right,  and  as- 
sume that  others  like  them  are  correct  also.  Where  suspicion 
is  aroused  more  care  is  obviously  necessary,  but  still  an  audi- 
tor is  not  bound  to  exercise  more  than  reasonable  care  and 


360  AUDITING. 

skill  even  in  a  case  of  suspicion,  and  he  is  perfectly  justified 
in  acting  on  the  opinion  of  an  expert  where  special  knowledge 
is  required. 

"  Mr,  Theobald's  evidence  satisfies  me  that  he  took  the  same 
view  as  myself  of  his  duty  in  investigating  the  company's 
books  and  preparing  his  balance  sheet.  He  did  not  content 
himself  with  making  his  balance  sheet  from  the  books  without 
troubling  himself  about  the  truth  of  what  they  showed.  He 
checked  the  cash,  examined  vouchers  for  payments,  saw  that 
the  bills  and  securities  entered  in  the  books  were  correct,  took 
reasonable  care  to  ascertain  their  value,  and  in  one  case  ob- 
tained a  solicitor's  opinion  on  the  validity  of  an  equitable 
charge.  I  see  no  trace  whatever  of  any  failure  by  him  in  the 
performance  of  this  part  of  his  duty. 

"  The  balance  sheet  and  certificate  of  February,  1892,  that 
is,  for  the  year  1891,  was  accompanied  by  a  report  to  the 
directors  of  the  bank.  Taking  the  balance  sheet,  the  certifi- 
cate, and  report  together,  Mr.  Theobald  stated  to  the  directors 
the  true  financial  position  of  the  bank,  and  if  this  report  had 
been  laid  before  the  shareholders,  Mr.  Theobald  would  have 
completely  discharged  his  duty  to  them.  Unfortunately,  how- 
ever, this  report  was  not  laid  before  the  shareholders,  and  it 
becomes  necessary  to  consider  the  legal  consequences  to  Mr. 
Theobald  of  this  circumstance. 

"  A  person  whose  duty  it  is  to  convey  information  to  others 
does  not  discharge  that  duty  by  simply  giving  them  so  much 
information  as  is  calculated  to  induce  them,  or  some  of  them, 
to  ask  for  more.  Information  and  means  of  information  are 
by  no  means  equivalent  terms.  Still,  there  may  be  circum- 
stances under  which  information  given  in  the  shape  of  a 
printed  document  circulated  amongst  a  large  body  of  share- 
holders would  by  its  consequent  publicity  be  very  injurious 
to  their  interests,  and  in  such  a  case  I  am  not  prepared  to 
say  that  an  auditor  would  fail  to  discharge  his  duty,  if  in- 
stead of  publishing  his  report  in  such  a  way  as  to  enisure 


APPENDIX  A.  361 

publicity,  he  made  a  confidential  report  to  the  shareholders, 
and  invited  their  attention  to  it,  and  told  them  where  they 
could  see  it.  The  auditor  is  to  make  a  report  to  the  share- 
holders, but  the  mode  of  doing  so,  and  the  form  of  the  re- 
port, are  not  prescribed.  If,  therefore,  Mr.  Theobald  had 
laid  before  the  shareholders  the  balance  sheet  and  the  profit 
and  loss  account  accompanied  by  a  certificate  in  the  form  in 
which  he  had  prepared  it,  he  would,  perhaps,  have  done 
enough,  under  the  peculiar  circumstances  of  the  case.  I  feel, 
however,  the  great  danger  of  acting  on  such  a  principle,  and 
in  order  not  to  be  misunderstood,  I  will  add  that  an  auditor 
who  gives  shareholders  means  of  information  instead  of  in- 
formation in  respect  of  a  company's  financial  position  does 
so  at  his  peril,  and  runs  the  very  serious  risk  of  being  held 
judicially,  to  have  failed  to  discharge  his  duty. 

"  In  this  case  I  have  no  hesitation  in  saying  that  Mr.  Theo- 
bald did  fail  to  discharge  his  duty  to  the  shareholders  in 
certifying  and  laying  before  them  the  balance  sheet  of  Feb- 
ruary, 1892,  without  any  reference  to  the  report  which  he 
laid  before  the  directors,  and  with  no  other  warning  than  is 
conveyed  by  the  words  '  The  value  of  the  assets  as  shown 
on  the  Balance  Sheet  is  dependent  upon  realization.'  The 
most  important  asset  on  that  balance  sheet  is  put  down  as 
'  Loans  to  customers  and  other  securities,  £346,975,'  and  on 
those  a  full  and  detailed  report  was  made  to  the  directors, 
showing  the  very  unsatisfactory  state  of  these  loans  and  se- 
curities, and  it  is  impossible  to  read  the  oral  evidence,  the 
report  of  Mr.  Balfour  and  Mr.  Brock,  dated  the  226.  of  De- 
cember, 1 89 1,  and  the  report  of  the  auditor  to  the  directors 
of  the  3d  of  February,  1892,  without  coming  to  the  conclusion 
that  the  entry  of  that  large  sum  as  a  good  asset  without  ex- 
planation was  unjustifiable.  It  is  a  mere  truism  to  say  that 
the  value  of  loans  and  securities  depends  upon  their  realiza- 
tion. We  are  told  that  a  statement  to  that  effect  is  so  un- 
usual that  the  mere  presence  of  those  words  is  enough  to  excite 
suspicion.     But,  as  already  stated,  the  duty  of  an  auditor  is 


362  AUDITING. 

to  convey  information,  not  to  arouse  inquiry,  and  although  an 
auditor  might  infer  from  an  unusual  statement  that  something 
was  seriously  wrong,  it  by  no  means  follows  that  ordina'ry 
people  would  have  their  suspicions  aroused  by  a  similar  state- 
ment if,  as  in  this  case,  its  language  expresses  no  more  than 
any  ordinary  person  would  infer  without  it. 

"  But  Mr.  Theobald  relies  on  the  fact  that  he  was  induced 
to  omit  from  his  certificate  all  reference  to  the  report  which 
he  made  to  the  directors,  because  Mr.  Balfour,  the  chairman, 
promised  to  mention  such  report  in  his  speech  to  the  share- 
holders, and  he  did  so.  But  although  Mr.  Balfour  twice 
alluded  to  the  report,  he  did  so  in  such  a  way  as  to  avoid 
attracting  attention  to  it.  The  second  time  he  mentioned  it 
was  after  a  dividend  had  been  declared,  and  when  a  motion 
to  re-appoint  the  auditors  was  before  the  meeting.  The  truth 
is  that  not  a  word  was  said  to  convey  to  the  shareholders  the 
substance  of  the  information  contained  in  the  report,  or  to 
induce  them  to  ask  any  question  about  it.  The  balance  sheet 
and  the  profit  and  loss  account  were  true  and  correct  in  this 
sense,  that  they  were  in  accordance  with  the  books.  But  they 
were,  nevertheless,  entirely  misleading,  and  misrepresented  the 
real  position  of  the  company.  Under  these  circumstances,  I 
am  compelled  to  hold  that  Mr.  Theobald  failed  to  discharge 
his  duty  to  the  shareholders  with  respect  to  the  balance  sheet 
and  certificate  of  February,  1892.  Possibly  he  did  not  realize 
the  extent  of  his  duty  to  the  shareholders  as  distinguished 
from  the  directors,  and  he,  unfortunately,  consented  to  leave 
the  chairman  to  explain  the  true  state  of  the  company  to  the 
shareholders  instead  of  doing  so  himself.  The  fact,  however, 
remains,  and  cannot  be  got  over,  that  the  balance  sheet  and 
certificate  of  February,  1892,  did  not  show  the  true  position 
of  the  company  at  the  end  of  1891,  and  that  this  was  owing 
to  the  omission  by  the  auditor  to  lay  before  the  shareholders 
material  information  which  he  had  obtained  in  the  course  of 
his  employment  as  auditor  of  the  company,  and  to  which  he 
called  the  attention  of  the  directors. 


APPENDIX  A.  363 

"  The  real  truth  is  that  the  assets  of  the  bank  were  put 
down  in  the  balance  sheet  at  far  too  high  a  figure,  and  this 
entry,  though  not  misleading  if  explained  (as  it  was  to  the 
directors),  was  seriously  misleading  in  the  absence  of  ex- 
planation." 

The  London  ^  General  Bank  case  just  cited  is  a  fair  ex- 
ample of  facts  which  charge  the  auditor  with  liability. 

In  Re  Kingston  Cotton  Mill   Co.,    2   Ch.   Div.    279,   decided 
in  the  Court  of  Appeal,  May  19,  1896. 

The  following  extract  taken  from  this  case  shows  facts 
which  do  not  charge  the  auditor  with  liability. 

"  I  come  now  to  the  real  question  in  this  controversy,  and 
that  is,  whether  the  appellants  have  been  guilty  of  any  breach 
of  duty  to  the  company.  To  decide  this  question  it  is  neces- 
sary to  consider  (i)  What  their  duty  was;  (2)  How  they 
performed  it,  and  in  what  respects  (if  any)  they  failed  to 
perform  it.  ...  I  protest  against  the  notion  that  an  audi- 
tor is  bound  to  be  suspicious,  as  distinguished  from  being 
reasonably  careful.  To  substitute  the  one  expression  for  the 
other  may  easily  lead  to  serious  error.  I  pass  now  to  consider 
the  complaint  made  against  the  auditors  in  this  particular 
case.  The  complaint  is  that  they  failed  to  detect  certain 
frauds.  There  is  no  charge  of  dishonesty  on  the  part  of  the 
auditors.  They  did  not  certify  or  pass  anything  which  they 
did  not  honestly  believe  to  be  true.  It  is  said,  however,  that 
they  were  culpably  careless.  The  circumstances  are  as  fol- 
lows :  For  several  years  frauds  were  committed  by  the  man- 
ager, who,  in  order  to  bolster  up  the  company  and  make  it 
appear  flourishing  when  it  was  the  reverse,  deliberately  ex- 
aggerated both  the  quantities  and  values  of  the  cotton  and 
yarn  in  the  company's  mills.  He  did  this  at  the  ends  of  the 
years  1890,  1891,  1892,  and  1893.  There  was  no  book  or  ac- 
count (except  the  Stock  Journal,  to  which  I  will  refer  pres- 
ently) showing  the  quantity  or  value  of  the  cotton  or  y:am  in 


364  AUDITING. 

the  mill  at  any  one  time.  It  would  not  be  easy  to  keep  such 
a  book.  Nor  is  it  wanted  for  ordinary  purposes.  There  is 
considerable  waste  (twenty  or  twenty-five  per  cent,  on  the 
average)  in  the  manufacture  of  yarn  from  cotton,  and  the 
market  prices  of  both  cotton  and  yarn  are  subject  to  great 
fluctuations.  The  balance  sheets  of  each  year  contained  on 
the  assets  side  entries  of  the  values  of  the  stock-in-trade  at 
the  end  of  the  year,  and  those  entries  were  stated  to  be  *  as 
per  manager's  certificate.'  There  were  also  in  the  balance 
sheets  entries  on  the  opposite  side  of  the  values  of  the  stock- 
in-trade  at  the  beginning  of  the  year.  The  quantities  did  not 
appear  in  either  case.  The  auditors  took  the  entry  of  the 
stock-in-trade  at  the  beginning  of  the  year  from  the  last  pre- 
ceding balance  sheet,  and  they  took  the  values  of  the  stock- 
in-trade  at  the  end  of  the  year  from  the  Stock  Journal.  The 
book  contained  a  series  of  accounts  under  various  heads  pur- 
porting to  show  the  quantities  and  values  of  the  company's 
stock-in-trade  at  the  end  of  each  year,  and  a  summary  of  all 
the  accounts,  showing  the  total  value  of  such  stock-in-trade. 
The  summary  was  signed  by  the  manager,  and  the  value  as 
shown  by  it  was  adopted  by  the  auditors,  and  was  inserted  as 
an  asset  in  the  balance  sheet,  but  '  as  per  manager's  certifi- 
cate.' The  summary  always  corresponded  with  the  accounts 
summarized,  and  the  auditors  ascertained  that  this  was  the 
case.  But  they  did  not  examine  further  into  the  accuracy  of 
the  accounts  summarized.  The  auditors  did  not  profess  to 
guarantee  the  correctness  of  this  item.  They  assumed  no 
responsibility  for  it.  They  took  the  item  from  the  manager, 
and  the  entry  in  the  balance  sheet  showed  that  they  did  so. 
I  confess  I  cannot  see  that  their  omission  to  check  his  returns 
was  a  breach  of  their  duty  to  the  company.  It  is  no  part  of 
an  auditor's  duty  to  take  stock.  No  one  contends  that  it  is. 
He  must  rely  on  other  people  for  details  of  the  stock-in-trade 
in  hand.  In  the  case  of  a  cotton  mill  he  must  rely  on  some 
skilled  person  for  the  materials  necessary  to  enable  him  to 
enter  the  stock-in-trade  at  its  proper  value  in  the  balance  sheet. 


APPENDIX  A.  365 

In  this  case  the  auditors  rehed  on  the  manager.     He  was  a 
man  of  high  character  and  of  unquestioned  competence.     He 
was  trusted  by  every  one  who  knew  him.    The  learned  judge 
has  held  that  the  directors  are  not  to  be  blamed  for  trusting 
him.     The  auditors  had  no  suspicion  that  he  was  not  to  be 
trusted  to  give  accurate  information  as  to  the  stock-in-trade 
in  hand,  and  they  trusted  him  accordingly  in  that  matter.   But 
it  is  said  they  ought  not  to  have  done  so,  and  for  this  reason. 
The  Stock  Journal  showed  the  quantities — that  is,  the  weight 
in  pounds — of  the  cotton  and  yarn  at  the  end  of  each  year. 
Other  books  showed  the  quantities  of  cotton  bought  during 
the  year  and  the  quantities  of  yarn  sold  during  the  year.     If 
these  books  had  been  compared  by  the  auditors  they  would 
have  found  that  the  quantity  of  cotton  and  yarn  in  hand  at 
the  end  of  the  year  ought  to  be  much  less  than  the  quantity 
shown  in  the  Stock  Journal,  and  so  much  less  that  the  value 
of  the  cotton  and  yarn  entered  in  the  Stock  Journal  could 
not  be  right,  or,  at  all  events,  was  so  abnormally  large  as  to 
excite  suspicion  and  demand  further  inquiry.    This  is  the  view 
taken  by  the  learned  judge.    But,  although  it  is  no  doubt  true 
that  such  a  process  might  have  been  gone  through,  and  that, 
if  gone  through,  the  fraud  would  have  been  discovered,  can 
it  be  truly  said  that  the  auditors  were  wanting  in  reasonable 
care  in  not  thinking  it  necessary  to  test  the  managing  direc- 
tor's returns?    I  cannot  bring  myself  to  think  they  were,  nor 
do  I  think  that  any  jury  of  business  men  would  take  a  different 
view.     It  is  not  sufficient  to  say  that  the  frauds  must  have 
been  detected  if  the  entries  in  the  books  had  been  put  together 
in  a  way  which  never  occurred  to  anyone  before  suspicion  was 
aroused.     The  question  is  whether,  no  suspicion  of  anything 
wrong  being  entertained,  there  was  a  want  of  reasonable  care 
on  the  part  of  the  auditors  in  relying  on  the  returns  made  by 
a  competent  and  trusted  expert  relating  to  matters  on  which 
information  from  such  a  person  was  essential.    I  cannot  think 
there  was.    The  manager  had  no  apparent  conflict  between  his 
interest  and  his  duty.    His  position  was  not  similar  to  that  of 


Z^  AUDITING. 

a  cashier  who  has  to  account  for  the  cash  which  he  receives, 
and  whose  own  account  of  his  receipts  and  payments  could  not 
be  reasonably  taken  by  an  auditor  without  further  inquiry. 

"  It  is  the  duty  of  an  auditor  to  bring  to  bear  on  the  work 
he  has  to  perform  that  skill,  care  and  caution  which  a  rea- 
sonably competent,  careful  and  cautious  auditor  would  use. 
What  is  reasonable  care,  skill  and  caution  must  depend  on  the 
particular  circumstances  of  each  case.  An  auditor  is  not 
bound  to  be  a  detective,  or,  as  was  said,  to  approach  his  work 
with  suspicion  or  with  a  foregone  conclusion  that  there  is 
something  wrong.  He  is  a  watch-dog,  but  not  a  bloodhound. 
He  is  justified  in  believing  tried  servants  of  the  company  in 
whom  confidence  is  placed  by  the  company.  He  is  entitled 
to  assume  that  they  are  honest  and  to  rely  upon  their  repre- 
sentations, provided  he  takes  reasonable  care.  H  there  is  any- 
thing calculated  to  excite  suspicion  he  should  probe  it  to  the 
bottom,  but  in  the  absence  of  anything  of  that  kind,  he  is  only 
bound  to  be  reasonably  cautious  and  careful.  His  Lordship 
then  referred  to  the  circumstances  which  led  to  the  auditors 
being  deceived,  and  came  to  the  conclusion  that  they  were  not 
wanting  in  skill,  care  or  caution,  in  accepting  the  figures  of 
the  manager,  and  he  concluded  as  follows: — The  duties  of 
auditors  must  not  be  rendered  too  onerous.  Their  work  is 
responsible  and  laborious,  and  the  remuneration  moderate.  I 
should  be  sorry  to  see  the  liability  of  auditors  extended  any 
further  than  In  re  The  London  and  General  Bank.  Indeed,  I 
only  assented  to  that  decision  on  account  of  the  inconsistency 
of  the  statement  made  to  the  directors  with  the  balance  sheet 
certified  by  the  auditors  and  presented  to  the  shareholders. 
This  satisfied  my  mind  that  the  auditors  deliberately  concealed 
that  from  the  shareholders  which  they  had  communicated  to 
the  directors.  It  would  be  difficult  to  say  this  was  not  a  breach 
of  duty.  Auditors  must  not  be  made  liable  for  not  tracking 
out  ingenious  and  carefully-laid  schemes  of  fraud,  when  there 
is  nothing  to  arouse  their  suspicion,  and  when  those  frauds  are 
perpetrated  by  tried  servants  of  the  company,  and  are  unde- 


APPENDIX  A.  367 

tected  for  years  by  the  directors.    So  to  hold  would  make  the 
position  of  an  auditor  intolerable." 

Wilde  and  others  against  Cape  and  Dalgleish,  decided  by 
the  Queen's  Bench  Division,  May  27,  1897  (reported 
unofficially  in  the  London  Times  of  May  28,  1897;  also  in 
the  "Accountant"  (Eng.),  June  5,  1897;  also  in  Dicksee's 
"  Auditing,"  7th  English  Ed.,  at  p.  679). 

Here  the  court  held  the  whole  question  to  be  simply  one  of 
fact,  to  wit:  Did  the  accountant  contract  and  agree  to  act 
as  a  simple  accountant,  and  merely  to  see  that  the  books  are 
brought  to  a  correct  balance,  taking  the  entries  and  balance 
in  the  books  as  correct;  or  on  the  other  hand  did  the  account- 
ant contract  and  agree  to  act  as  an  auditor  and  make  a  cash 
audit,  and  check  receipts  and  payments,  and  examine  the  cash 
and  bank  book  and  be  responsible  for  the  accuracy  of  the  cash 
transactions  ? 

Irish  "Woolen  Company,  Lim.,  against  Tyson  and  others, 
decided  by  the  Irish  Court  of  Appeal,  January  20,  1900 
(unofficially  reported  in  the  "Accountant"  (Eng.),  Feb- 
ruary 3,  1900;  also  in  Acct.  L.  R.  1900,  p.  13;  also  in 
Dicksee's  Auditing,  7th  Eng.  Ed.,  p.  702.) 

In  this  case  it  was  held  that  when  the  accounts  of  a  com- 
pany have  been  falsified  and  dividends  improperly  paid  out  of 
capital  in  consequence,  the  auditor  is  liable  if  the  falsifica- 
tions might  have  been  discovered  by  the  exercise  of  reasonable 
care  and  skill  from  an  inspection  of  the  books  themselves. 

"  An  accountant  with  a  large  business  is  not  supposed  to 
do  everything  himself.  The  auditor  is  bound  to  give  reason- 
able care  and  skill,  but  this  can  also  be  exercised  by  his 
deputy.  I  do  not  think  there  is  anything  to  be  gained  by 
considering  in  the  abstract  the  duties  of  an  auditor  of  a  joint- 
stock  company.  He  is  entitled  to  see  the  company^s  books 
and  the  materials  for  their  books,  and  also  to  ask  for  explana- 


368  AUDITING. 

tions.  But  he  is  not  called  on  to  seek  for  knowledge  outside 
the  company,  or  to  communicate  with  customers  or  creditors. 
He  is  not  an  insurer  against  fraud  or  error;  and  if  fraud  is 
alleged  it  must  be  shown  with  precision  the  acts  of  negligence 
for  which  he  is  said  to  be  responsible.  Nine  balance  sheets 
were  prepared,  and  the  figures  on  some  represent  the  aggre- 
gate amount  of  many  items,  but  I  propose  to  deal  only  with 
matters  that  have  been  referred  to  during  the  hearing.  There 
are  three  sets  of  figures  with  which  I  will  deal : —  ( i )  Stock- 
in-trade;  (2)  sundry  debtors;  (3)  sundry  creditors  on  the  lia- 
bility side  of  the  balance  sheet.  Taking  these  in  order 
.  .  .  There  was  certainly  no  duty  cast  on  the  auditor  to 
take  stock.  What  he  did  was  to  have  the  calculations  checked 
in  his  office,  and  this  was  done  with  proper  care.  Mr.  Kevans 
said  he  was  particularly  careful  as  to  the  deduction  for  dis- 
count, and,  as  far  as  I  could  gather,  the  imiversal  rate  of  ten 
per  cent,  seems  reasonable.  Moreover,  an  auditor  has  nothing 
to  do  with  the  terms  upon  which  the  company,  or  a  trader, 
buys  or  sells.  .  .  .  As  to  the  provision  for  the  *  bad  debts,' 
if  there  is  any  one  thing  upon  which  an  auditor  is  dependent 
upon  the  officers  it  is  the  writing  off,  or  the  making  of  a  pros- 
pective allowance  for,  bad  debts.  He  has  no  personal  knowl- 
edge of  the  customers,  and  Mr.  Kevans  seems  to  have  taken 
particular  attention  in  reference  to  this.  (See  questions  2,125 
to  2,127  in  the  evidence.)  He  said  '  he  had  some  special  knowl- 
edge on  the  subject,  that  he  saw  all  ascertained  bad  debts  duly 
written  off,  and  that  there  was  a  fund  amounting  to  £500  as 
a  provision  therefor.'  For  the  foregoing  reasons  there  is  no 
ground  for  alleging  negligence  against  Mr.  Kevans  on  the 
*  assets  side  '  of  the  balance  sheet.  .  .  .  Now,  dealing 
with  'sundry  creditors  ' ;  here,  evidently,  there  is  a  fraud,  and 
a  curious  thing  is  that  no  one  seemed  to  have  derived  any 
benefit  from  the  fraud.  Dealing  with  the  invoices,  the  learned 
judge  detailed  the  practice  in  connection  with  the  statements 
of  accounts  being  laid  before  the  meeting,  and  said,  the  ledger 
was  used  for  the  purchases  made  and  for  the  payments  on  ac- 


APPENDIX  A.  369 

count  thereof.  If,  then,  all  this  were  rightly  done  it  would  be 
easy  for  the  auditor  to  ascertain  the  amounts  due  to  the  credi- 
tors, but,  unfortunately,  the  books  were  not  correctly  kept. 
The  creditors'  accounts  in  the  ledger  did  not  show  all  the 
goods  purchased  up  to  the  time  of  the  audit,  nor  could  the 
auditor  discover  the  omissions  on  account  of  many  of  the  in- 
voices being  either  '  suppressed '  or  not  put  into  the  book  until 
a  later  date — sl  process  described  as  '  carrying  over.'  There  is 
some  doubt  as  to  whether  the  deficiency  arose  from  the  sup- 
pression or  the  carrying  over,  but  my  impression  is  that  the 
whole  of  it  comes  within  the  last-mentioned  class,  for  at  the 
end  of  1894,  we  find  they  amounted  to  £4,095.  Mr.  Peter 
White  is  now  dead,  and  he  should  not  be  condemned  unheard, 
but  it  is  difficult  to  believe  that  this  system  was  not  within  his 
own  knowledge.  As  chief  promoter  he  was  no  doubt  anxious 
to  see  that  the  company  was  successful;  Crawford,  who  was 
the  secretary,  appears  to  have  continued  the  process.  It  seems 
strange  that  a  system  of  fraud  so  long  continued,  and  for  so 
extensive  a  period,  was  never  detected  by  the  auditor.  Once 
or  twice  he  noticed  something,  and  the  explanation  that  was 
g^ven  was  'that  the  goods  were  not  taken  into  stock.'  The 
question  is,  Was  it  negligent  not  to  have  seen  this?  There  is 
no  doubt  that  both  the  suppression  and  carrying  over  of  in- 
voices would  have  been  detected  if  the  auditor  had  called  for 
the  creditors'  statements  of  accounts  upon  which  payment  was 
ordered,  and  compared  them  with  the  ledger.  I  should  have 
thought  this  was  part  of  the  auditor's  duty  for  many  reasons ; 
but  all  the  accountants  examined,  except  Mr.  Southworth, 
stated  that  this  course  is  never  taken  unless  there  is  something 
to  arouse  suspicion.  Mr.  Pixley,  the  eminent  London  account- 
ant, says  it  could  not  well  be  done  except  in  the  case  of  a  very 
small  concern.  In  the  face  of  such  evidence,  I  should  not  leave 
myself  at  liberty  to  hold  that  Mr.  Kevans'  assistants  were 
guilty  of  negligence  in  not  looking  at  these  statements  of  ac- 
count if  they  were  engaged  in  an  ordinary  audit.  Little  time 
is  allowed  for  doing  so ;  but  in  this  case  there  was  this  systerti 
•of  monthly  checking.     From  the  time  that  Crawford  was  ac- 


37^  AUDITING. 

countant  in  1890  the  accounts  of  the  company  were  completely 
in  his  hands.  Now,  White  for  the  two  years  following  may 
have  given  general  directions,  but  he  was  often  away  in  Amer- 
ica for  months  at  a  time,  and  it  is  clear  that  the  monthly  audit 
was  instituted  for  the  purpose  of  seeing  that  he  (Crawford) 
would  do  his  work  regularly  and  honestly.  I  am  unable  to 
conceive  how,  if  there  was  nothing  wrong  about  this  monthly 
checking,  it  did  not  lead  at  an  early  period  to  the  detection  of 
the  frauds  in  this  ledger.  Mr.  Kevans  ought  to  have  found 
out,  by  the  accounts,  the  payments  that  were  made — and  no 
better  means  could  be  adopted  than  that  of  a  comparison  with 
the  statements  of  accounts.  It  ought  to  have  been  done  in 
some  way,  and,  if  it  had,  detection  would  have  been  certain. 
I  do  not  base  my  decision  on  this  alone;  apart  altogether  from 
the  statements  of  account  and  the  monthly  check,  I  do  not 
understand  how  the  carrying  over  of  the  invoices  could  have 
escaped  detection  by  the  accountant,  who  should  have  used  due 
care  and  skill,  and  who  was  not  a  mere  machine.  The  invoices 
carried  over  were  ultimately  posted  to  the  ledger.  If  they 
were  posted  to  their  true  dates,  it  would  be  at  once  apparent 
that  they  were  not  entered  in  at  the  proper  time.  If  they  were 
posted  under  false  dates,  why  was  this  not  detected  when  the 
ledger  accounts  were  checked  with  the  invoices?  And  when 
no  invoices  came  into  the  books,  it  is  admitted  that  this  ought 
to  have  excited  suspicion.  For  these  reasons  I  am  of  opinion 
that  if  due  care  and  skill  had  been  exercised,  the  carrying  over 
and  suppression  of  invoices  would  have  been  discovered,  and 
the  auditor  is  liable  for  any  damage  the  company  may  have 
sustained  from  the  understatement  of  liabilities  in  the  balance 
sheet  due  to  this  cause  since  January  4,  1892.  I  consider  that 
not  only  are  Mr.  Kevans  and  his  assistants  not  free  from  blame 
for  this,  but  also  for  the  mechanical  way  the  audit  was  car- 
ried out. 

"  As  regards  the  measure  of  the  duty  of  a  gentleman  em- 
ployed, as  Mr.  Kevans  was  in  this  case,  the  result  is  the  same, 
as  it  occurs  to  me,  in  all  cases  in  which  professional  skill  is 


APPENDIX  A.  371 

employed,  except  one,  the  peculiar  instance  of  a  barrister. 
The  measure  of  duty  is  the  bringing  of  reasonable  care  and 
skill  to  the  performance  of  the  business  directed  to  be  done, 
having  regard,  first  to  the  contract  of  employment,  then  to  the 
character  of  the  business  itself,  to  the  remuneration  of  the 
defendant,  and  to  all  the  other  circumstances  of  the  case.  In 
strict  rule,  however,  the  measure  of  the  duty  is  to  be  ascer- 
tained by  applying  to  all  the  circumstances  of  the  case  the 
best  consideration,  so  as  to  ascertain  what  ought  to  have  been 
done  under  the  circumstances.  ...  I  think  the  fairest 
way  to  deal  with  Mr.  Kevans  in  this  case  is  to  treat  him  as 
being  charged  with  having  failed  to  find  just  cause  of  suspicion 
on  the  face  of  these  books,  which,  if  found,  would  have  im- 
posed on  him  the  duty  of  pursuing  his  suspicion  until  he  found 
whether  it  was  or  was  not  well  founded.  .  .  .  The  Eng- 
glish  cases  have  established  that  the  auditor  is  entitled,  in  the 
absence  of  the  elements  of  suspicion,  to  assume  that  the  books 
are  honestly  kept,  and  that,  therefore,  unless  on  the  face  of  a 
presumably  honest  book  something  appears  to  excite  his  sus- 
picion, he  is  not  guilty  of  negligence,  whatever  other  people 
might  be  in  their  departments,  if  he  does  not  discover  that 
something  was  wrong.'*     .     .     . 

(The  suspicious  circumstance  in  this  case  is  then  referred 
to  by  the  Court  as  follows:) 

"  I  cannot  conceive  any  more  clear  or  glaring  grounds  of 
suspicion  than  to  discover  in  the  account  of  a  single  customer 
items  amounting  to  £600  having  got  into  the  books  after  the 
trial  balance  is  struck  under  dates  going  back  two  months 
prior  to  the  period  of  the  ascertaining  of  the  trial  balance. 
.  .  .  .  It  appears  to  me  that  the  moment  I  come  to  the 
conclusion  that  that  was  on  the  face  of  it  a  suspicious  mode  of 
dealing  with  Hill  &  Son's  figures,  I  am  bound  to  show  how 
it  would  be  corrected.  .  .  .  That  it  would  then  have  been 
necessary  to  call  for  the  creditors'  statements  of  account,  and 
at  that  moment  they  would  have  disclosed  on  the  face  of  them 
not  merely  those  postdated  items,  but  the  suppressed  invoices 


37^  AUDITING. 

also;  and  at  the  instant  that  this  discovery  was  made  there 
is  an  absolute  conviction  of  something  wrong  forced  upon  the 
mind  of  the  auditor.  It,  therefore,  occurs  to  me  that,  upon 
these  two  branches,  all  that  is  required,  both  to  show  the  negli- 
gence, to  arouse  suspicion,  and  to  supply  the  means  of  putting 
a  stop  to  the  frauds,  is  to  be  found  on  the  face  of  the  books, 
and  for  all  I  have  said  I  have  no  foundation  except  what  is 
upon  the  face  of  that  book  (Creditors'  Ledger)." 

The  converse  of  the  Irish  Woollen  Co,  case  is  found  in 

Short  and  Compton  v.  Brackett,  Colchester  County  Court* 
May  6,  1904  (unofficially  reported  in  the  "  Accountant " 
(Eng.),  May  14,  1904;  also  in  Acct.  L.  R.  1904,  p.  85;  also 
in  Dicksee's  "Auditing,"  7th  Eng.  Ed.,  p.  813). 

There  the  clerk  made  out  a  wage  bill  each  week  for  a  larger 
amount  than  was  due  to  the  men  and  kept  the  balance.  An 
auditor  examined  the  books  on  behalf  of  an  incoming  partner. 
At  the  time  of  the  examination  there  was  no  suspicion  against 
the  clerk,  and  there  was  nothing  on  the  face  of  the  books  to 
arouse  suspicion. 

Judge  Tindal  Atkinson  held  that,  having  regard  to  the  ob- 
ject for  which  they  were  employed,  the  plaintiffs  were  entitled 
to  assume  that  the  figures  appearing  in  the  defendant's  books 
as  paid  for  wages  were  correct,  and  in  view  of  the  fact  that 
at  the  time  there  was  no  suspicion  of  any  defalcation  by  the 
defendant's  clerk  alluded  to,  he  thought  there  was  no  negli- 
gence on  their  part.  Therefore  judgment  would  be  for  plain- 
tiffs on  the  claim  with  costs. 

It  is  important  to  bear  in  mind  here  that  no  audit  in  the 
proper  sense  of  the  term  was  ever  performed,  in  that  the  in- 
vestigating accountant  (being  presumably  employed  by  the 
incoming  partner)  owed  no  duties  to  the  existing  partners. 
As  pointed  out  in  Chapter  XI.,  in  investigations  as  to  profits, 
the  object  is  to  make  sure  that  the  profits  have  not  been  ex- 
aggerated, rather  than  to  see  whether  they  have  not  been 
understated  and  the  difference  misappropriated  by  employees. 


APPENDIX  A.  373 

London  Oil  Storage  Co.,  Lim.,  against  Seear,  Hasluck  CBi»  Co., 
King's  Bench  Division,  June  1, 1904;  unofficially  reported  in 
the  London  Times,  June  2,  1904;  also  in  the  "Accountant  " 
(Eng.),  July  2,  1904;  also  in  Acct.  L.  R.  XXXL,  p.  1;  also 
in  Dicksee's  "Auditing,"  7th  Eng.  Ed.,  p.  815). 

In  this  case  the  auditor  took  no  steps  to  verify  the  existence 
of  petty  cash  as  stated  in  the  balance  sheet.  The  balance 
sheet  showed  £796  petty  cash,  whereas  only  £30  was  actually 
in  the  cash  box,  the  bookkeeper  having  embezzled  the  differ- 
ence. The  court  left  it  for  the  jury  to  find  as  matter  of  fact, 
whether  or  not  the  auditor's  failure  to  verify  this  balance  was 
negligent  under  the  circumstances.  The  court  charged  the 
jury  in  part  as  follows: — 

"  The  auditor  most  undoubtedly  does  undertake  very  con- 
siderable responsibilities,  and  is  liable  for  the  proper  discharge 
of  his  duties,  and  if  by  the  neglect  of  his  duties,  or  by  want  of 
reasonable  care,  he  neglects  his  duty,  and  damage  is  caused 
to  the  company  as  such,  he  is  responsible  for  that  damage. 
I  will  not  adopt  any  fanciful  expression  which  may  be  quoted 
from  any  particular  judgment,  but  he  has  got  to  bring  to 
bear  upon  those  duties  reasonable  and  watchful  care,  he  has 
got  to  discharge  those  duties  remembering  that  the  company 
look  to  him  to  protect  their  interests.  He  is  not,  however, 
supposed  to  be  a  man  constantly  going  about  suspecting  other 
people  of  doing  wrong,  and  that  is  the  only  respect  in  which, 
I  think,  Mr.  Bankes  in  his  most  able  speech  pressed  the  mat- 
ter a  little  too  high.  While  Mr.  Hasluck  has  by  the  exercise  of 
due  and  reasonable  care  to  see  that  all  the  officials  of  the 
company  are  doing  their  duty  properly  in  so  far  as  the  ac- 
counts are  concerned,  he  is  not  bound  to  assume  when  he 
comes  to  do  his  duty  that  he  is  dealing  with  fraudulent  and  dis- 
honest people;  and  there  comes  in  the  most  important  con- 
sideration from  one  point  of  view — ^perhaps  more  important 
than  the  other,  though  I  do  not  think  of  such  substantial 
weight  in  the  matter — if  circumstances  of  suspicion  arise,  it 
is  the  duty  of  the  auditor,  in  so  far  as  those  circumstances 


374  AUDITING. 

relate  to  the  financial  position  of  the  company,  to  probe  them 
to  the  bottom." 

It  will  be  seen  that  this  rather  follows  the  obiter  dictum  in 
the  Kingston  Cotton  Ad  ill  case,  p.  363,  as  to  the  obvious  con- 
flict between  the  interest  and  the  duty  of  a  cashier.  The  point 
is,  of  course,  made  all  the  clearer  by  the  circumstance  that  so 
large  a  balance  of  Petty  Cash  would  be  unprecedented  as  to 
naturally  call  for  inquiry  if  the  least  care  were  being  taken. 
It  should  be  noted  that  in  this  case  the  damages  awarded  were 
not  at  all  in  the  nature  of  compensation  for  the  loss  sustained 
by  the  plaintiffs,  but  merely  represent  a  nominal  sum  to  mark 
the  fact  that  the  audit  had  not  been  performed  with  all  due 
care. 

Herbert  Alfred  Burleigh  against  Ingram  Clark,  Lim., 
Chancery  Division,  April  2,  1901  (unofficially  reported  in 
the  "Accountant"  (Eng.),  April  27,  1901;  also  in  Acct. 
L.  R.  1901,  p.  65;  also  in  Dicksee's  "Auditing,"  7th  Eng. 
Ed.,  p.  765.) 

This  case  decided  that  an  accountant  has  a  lien  on  such 
books  as  he  has  actually  worked  upon  for  the  work  done  upon 
those  books  only.  The  judges  also  said  by  way  of  dictum  that 
an  auditor  had  no  such  lien.  The  distinction  between  ac- 
countant and  auditor,  as  drawn  in  this  case,  is  that  the  ac- 
countant does  work  on  the  books,  and  the  auditor  does  work 
in  respect  of  the  books.  The  accountant  actually  writes  in  the 
books  themselves,  while  the  auditor  merely  looks  at  the  book?, 
and  does  his  work  on  other  pieces  of  paper. 

Martin  v.  Isitt,  decided  before  Lord  Chief  Justice  Russell,  in 
the  Queen's  Bench  Division,  March  3  and  4,  1898,  (unoffici- 
ally reported  in  Acct.  L.  R.  1898  p.  41;  also  in  Dicksee's 
"Auditing,"  7th  Eng.  Ed.  p:  68O). 

Considerable  interest  attaches  to  the  foregoing  case  on  ac- 
count of  the  discussion  therein  as  to  the  duties  of  an  auditor 
to  attend  promptly  to  periodical  audits. 


APPENDIX  A.  375 

This  was  an  action  brought  by  Messrs.  James  Martin  & 
Sons,  milk  and  grain  merchants,  against  Messrs.  Isitt  &  Co., 
Chartered  Accountants,  for  negHgence  in  not  checking  the 
cash  book  and  the  bank  pass  book,  whereby  a  clerk  was  en- 
abled undiscovered  to  embezzle  £612  19s.  2d.,  the  property  of 
the  plaintiffs.  The  defendants  alleged  that  they  were  unable 
to  properly  proceed  with  their  agreed  work,  owing  to  the 
neglect  of  the  plaintiffs  to  give  proper  facilities,  and  in  par- 
ticular they  complained  that  the  books  were  not  properly 
posted  up  and  were  full  of  errors,  of  which  the  defendants 
were  unable  to  get  the  necessary  explanations. 

It  appeared  that  in  1887  Mr.  Eldrid,  now  a  member  of  the 
defendants'  firm,  agreed  with  plaintiffs  to  do  certain  work 
which  was  not  material  to  the  present  action,  and  also  under- 
took the  *'  monthly  checking  of  all  your  books  "  for  an  in- 
clusive fee  of  thirty  guineas,  afterwards  increased  to  sixty 
guineas.  It  was  not  the  defendants'  duty  to  audit,  but  merely 
to  "  check  "  the  books.  To  enable  this  to  be  done  clerks  were 
sent  down  to  the  plaintiffs'  head  office  at  Brockley,  and  they 
spent  there  a  very  considerable  number  of  hours  doing  the 
requisite  work.  The  books  were  written  up  and  posted  by 
the  plaintiffs  themselves ;  with  this  the  defendants  had  nothing 
to  do.  It  further  appeared  that  a  man  named  May,  in  charge 
of  a  branch  of  the  plaintiffs'  business,  received  money,  and  in 
a  weekly  statement  sent  to  the  plaintiffs  credited  himself  with 
payments  into  a  bank,  which  payments  should  in  ordinary 
course  appear  in  the  London  and  County  Bank  pass  book  of 
the  plaintiffs.  In  fact,  from  the  last  week  of  November,  1896, 
until  the  end  of  March,  1897,  he  habitually  embezzled  the 
money.  The  plaintiffs  would  enter  in  their  cash  book  the 
amount  alleged  by  May  to  have  been  paid  into  the  bank;  the 
pass  book,  of  course,  would  not  agree  with  cash  book,  and 
the  plaintiffs  complained  that  this  was  not  discovered  until 
the  first  days  of  April,  1897.  It  was  admitted  that  the  dis- 
covery was  made  by,  and  was  due  to  the  work  of  the  defend- 
ants; but  it  was  then  alleged  against  the  defendants  that  the 


Z7^  AUDITING. 

discovery  should  have  been  made  earHer.  The  reply  of  the 
defendants  to  this  was  that  the  state  of  the  books  was  such, 
and  the  queried  items — the  explanations  of  which  were  con- 
stantly delayed — were  so  numerous,  that  they  were  unable  to 
proceed  fast  enough  to  keep  pace;  and  that,  in  December, 
1896,  they  were  still  engaged  in  dealing  with  the  entries  relat- 
ing to  the  summer  months  of  1896.  Further,  they  said 
that  they  were  requested  by  the  plaintiffs  not  to  proceed  with 
the  work  in  January,  and  that  the  month  of  February  was 
wasted  away  to  the  default  of  the  plaintiffs.  The  senior  mem- 
ber of  the  plaintiffs'  firm  was  called,  and  gave  evidence  sup- 
porting his  own  and  negativing  the  defendants'  case,  but  his 
cross-examination  was  not  concluded  when  the  court  rose 
for  the  day. 

Before  resuming  the  hearing  next  morning,  a  consultation 
took  place  between  counsel,  and  as  a  result,  Mr.  Carson  stated 
that  he  understood  that  it  would  not  now  be  contended  that  the 
defendants  had  been  negligent  or  unskilful  in  the  way  in  which 
they  had  done  their  work,  but  that  the  plaintiffs  would  rest 
their  case  on  a  breach  of  one  term  of  the  contract — viz.,  the 
agreement  to  attend  monthly.  That  being  so,  and  recognizing 
that  the  plaintiffs  had  suffered  a  loss,  the  defendants  were 
quite  willing  to  share  that  loss  to  a  certain  extent,  and  con- 
sequently terms  had  been  arranged. 

The  Lord  Chief  Justice  said  that  as  he  understood  the  case 
as  placed  before  hirrt,  no  allegation  of  negligence  or  unskilful- 
ness  was  now  made,  but  that  it  was  urged  that  the  defendants 
should  have  attended  somewhat  earlier  than  they  actually  did; 
that  was  a  question  to  be  tried,  but  he  thought  the  action  of 
the  parties  in  arranging  the  matter  to  be  very  proper. 

Smith  against  Sheard,  Liverpool  Assizes,  May  11,  1906  (re- 
ported in  the  "Accountant,"  L.  R.  1906,  p.  65;  also  in 
Dicksee's  ^'Auditing,"  7th  Eng.  Ed.,  p.  833.) 

Claim  was  made  by  the  plaintiff  that,  in  consequence  of 
the  inefficient  auditing  of  the  books  by  the  defendant,  the  em- 


APPENDIX  A.  377 

bezzlement  of  some  £700  by  the  plaintiff's  cashier  had  not 
been  detected.  The  defense  was  that  no  agreement  had  ever 
been  made  for  a  complete  audit,  but  that  the  only  work  contem- 
plated was  the  stating  of  the  accounts  between  partners,  and 
later,  after  one  of  the  partners  had  withdrawn,  on  behalf  of 
creditors,  the  books  being  accepted  as  they  stood,  and  only 
such  auditing  done  as  was  absolutely  necessary  to  the  prepa- 
ration of  statements. 

The  case  was  tried  before  a  special  jury,  and  the  charge 
of  the  trial  judge  seemed  to  be  very  favorable  to  the  defend- 
ant. The  jury,  however,  found  for  the  plaintiff,  thus  assent- 
ing to  the  allegation  that  there  had  been  an  agreement  for  a 
complete  audit.  This  case  shows  the  extreme  importance  of 
a  distinct  understanding,  not  only  verbal,  but  written,  when 
a  partial  audit  is  to  be  made  or  statements  to  be  prepared 
without  any  audit  whatever. 

Newton  against  Birmingham  Small  Arms  Company,  Lim., 
Chancery  Division,  June  27,  1906  (reported  in  22  Times 
L.  R.,  p.  644 ;  also  in  Dicksee's  "Auditing,"  7th  Eng.  Ed., 
p.  872.) 

The  Birmingham  Small  Arms  Company,  Limited,  had  passed 
a  special  resolution  purporting  to  alter  the  company's  articles 
of  association,  the  material  part  of  which  read  as  follows : 

**  In  addition  and  without  prejudice  to  Articles  132  and 
133  "  (which  related  to  the  formation  of  and  dealing  with  a 
reserve  fund),  "  the  directors  may  in  any  year  in  which  they 
shall  recommend  a  dividend  to  be  paid  on  the  ordinary  shares 
.  .  .  of  not  less  than  10  per  cent,  on  the  amount  paid  up 
thereon  set  aside  (without  disclosing  the  fact)  out  of  the 
earnings  or  profits  in  such  year  remaining  after  providing  the 
amounts  necessary  to  pay  the  dividends  payable  on  preference 
shares  and  the  dividend  which  they  recommend  on  the  ordi- 
nary shares  such  a  sum  as  they  may  deem  necessary  or  de- 
sirable in  the  interest  of  the  company  as  an  internal  reserve 


378  AUDITING. 

fund  or  as  an  addition  to  such  internal  reserve  fund  when 
formed,  which  internal  reserve  fund  shall  be  held  upon  the 
terms  and  for  the  purposes  following,  that  is  to  say:  (a)  The 
internal  reserve  fund  shall  be  separate  from  the  reserve  fund 
under  Article  132,  and  need  not  be  shown  or  disclosed  by 
the  balance  sheet,  and  the  directors  need  not  give  any  informa- 
tion to  the  shareholders  as  to  the  amount,  investment,  or  ap- 
plication thereof,  or  otherwise  in  relation  thereto,  either  in 
their  report  or  otherwise,  (b)  Such  internal  reserve  fund 
may  be  invested  upon  such  investments  (other  than  the 
shares  of  the  company)  as  the  directors  may,  in  their  abso- 
lute discretion,  think  fit,  without  being  liable  for  any  deprecia- 
tion of  or  loss  in  consequence  of  such  investments.  .  .  . 
(c)  Such  internal  reserve  fund  may  be  used  and  applied  at 
the  discretion  of  the  directors  for  any  purpose  for  which  the 
ordinary  reserve  fund  is  available,  or  for  any  purposes  which 
the  directors  in  their  absolute  discretion  may  consider  will 
serve,  protect,  or  advance  the  interests  of  the  company,  or 
preserve  or  promote  the  value  of  the  undertaking,  assets,  or 
goodwill  of  the  company,  (d)  The  directors  shall  disclose 
the  internal  reserve  fund  and  the  amount  thereof,  and  all 
additions  thereto,  and  all  other  particulars  in  respect  to  the 
said  fund  to  the  auditors  of  the  company  appointed  by  the 
shareholders,  whose  duty  shall  be  to  see  that  the  same  is 
applied  for  the  purposes  of  the  company  in  accordance  with 
the  provisions  hereinbefore  contained,  but  not  to  disclose  any 
information  with  regard  to  the  same  to  the  shareholders  or 
otherwise." 

The  shareholders  of  the  company  brought  an  action,  declar- 
ing that  the  resolution  was  ultra  vires  and  invalid,  and  asked 
for  an  injunction  to  restrain  the  company  and  its  directors 
from  acting  on  such  a  resolution.  Particular  exception  was 
taken  to  that  part  of  the  resolution  which  was  to  prevent  the 
auditors  appointed  by  the  shareholders  from  disclosing  any 
information  with  regard  to  the  same  to  the  shareholders  or 
otherwise.     It  was  claimed  by  counsel  for  the  plaintiff  that 


APPENDIX  A.  379 

this  would  prevent  the  auditors  from  properly  complying  with 
the  sections  of  the  Companies  Acts  under  which  they  were 
appointed  and  under  which  the  auditors  had  to  report  to  the 
shareholders.  An  injunction  to  restrain  the  company  from 
acting  on  this  special  resolution  was  granted.  In  pronounc- 
ing judgment,  Mr.  Justice  Buckley  stated  inter  alia  that  he 
considered  it  inconsistent  with  the  Act  of  Parliament  (Com- 
panies' Act  of  1900),  that  the  auditor  should  be  bound,  even 
when  he  thinks  that  the  true  state  of  the  company's  affairs  is 
affected  by  facts  relating  to  the  internal  reserve  fund,  to  with- 
hold all  information  with  regard  to  the  same  from  the  share- 
holders. 


APPENDIX  B. 


Professional  Ethics. 

Every  profession,  which  is  worthy  of  the  designation,  must 
have  a  code  of  ethics  which  shall  be  observed  by  its  members 
in  the  pursuit  of  their  professional  duties.  It  does  not  follow 
that  the  code  need  be  written,  though  this  has  in  some  cases  its 
advantages,  but  it  is  necessary  that  there  be  certain  well  under- 
stood principles,  the  violation  of  which  shall  mark  the  violator 
as  unworthy  of  professional  standing.  The  development  of 
professional  standards  and  the  recognition  of  the  underlying 
principles  has  taken  many  years  in  the  older  professions.  This 
subject  has  had  the  careful  attention  and  consideration  of  those 
engaged  in  the  practice  of  accountancy,  who  have  the  welfare 
and  the  development  of  the  profession  along  broad  lines  at 
heart.  At  the  St.  Paul  convention  of  the  American  Associ- 
ation of  Public  Accountants,  held  in  October,  1907,  an  ad- 
mirable paper  on  "  Professional  Ethics  "  was  presented  by  J. 
E.  Sterrett,  C.  P.  A.,  and  in  the  course  of  the  discussion  which 
followed  John  A.  Cooper,  C.  P.  A.,  proposed  the  following: 

CODE  OF  ETHICS. 
Service. 

1.  To  certify  to  statements,  exhibits,  schedules  or  other  form 

of  accountancy  work,  the  auditing  or  preparation  of 
which  was  not  carried  on  entirely  under  the  supervision 
of  himself,  a  member  of  his  firm,  or  one  of  the  staff,  is 
wrong. 

2.  The  use  of  a  practitioner's  nam.e  in  professional  work  by 

others  than  partners  or  employees  is  wrong  in  that  it 
implies  deception. 

3.  To  perform  accountancy  work,  payment  for  which  is  by 

arrangement  upon  the  contingency  of  the  result  of  liti- 
gation or  other  form  of  adjustment,  is  unprofessional. 

380 


CODE  OF  ETHICS.  381 

4.  The  payment  of  a  commission,  brokerage  or  other  form  of 

inducement  to  the  laity  from  professional  fees  is  wrong. 

5.  The  acceptance  of  any  part  of  the  fees  of  a  lawyer  or  any 

commercial  brokerage,  bonus  or  commission,  as  an  in- 
cident arising  out  of  a  practitioner's  service,  is  wrong. 

6.  Active  interest  in  a  commercial  enterprise  while  practicing 

as  a  public  accountant  is  to  be  avoided,  as  incompatible 
with  strict  ethical  principles. 

7.  The  practitioner  should,  wherever  possible,  avoid  acting 

as  a  trustee  of  special  funds  or  pools  as  an  incideat  of 
his  calling. 

8.  A  practitioner  should  avoid  serving  as  a  director  in  cor- 

porations in  which  he  is  professionally  employed. 

Clients. 

1.  Upon  engagement  a  practitioner  is  in  duty  bound  to  tell 

his  client  of  all  foreknowledge  he  may  have  had  touch- 
ing the  matter  under  consideration. 

2.  Personal  responsibility  is  a  fundamental  rule  of  the  pro- 

fession. A  practitioner  cannot  screen  himself  from  the 
specific  acts  or  laches  of  his  employees ;  the  responsibili- 
ties are  his  and  those  of  his  firm. 

3.  Information  acquired  in  the  course  of  service  is  privileged 

and  inviolable.  Abuse  thereof  to  the  detriment  of  a  for- 
mer client  renders  a  member  subject  to  the  severest 
discipline. 

4.  Efforts  that  tend  to  invite  or  encourage  legal  contest,  or 

foster  further  employment  by  neglect,  manipulation  or 
unfinished  service,  should  be  severely  dealt  with;  it  is, 
in  fact,  barratry. 

5.  To  recommend  or  advise  clients  to  a  measure  or  course 

of  procedure  that  may  even  indirectly  give  the  practi- 
tioner a  personal  advantage  must  be  considered  as  fla- 
grant professional  infidelity  and  misconduct.  It  is 
"  maintenance,"  and  is  punishable  as  such  at  common 
law. 


382  AUDITING. 

Inter-Professional. 

1.  Depreciation  of  opponents  in  contested  matters  is  unpro- 

fessional and  ethically  wrong. 

2.  Acceptance  of  an  appointment  from  which  a  colleague  has 

withdrawn  from  conscientious  motives,  without  previ- 
ously making  direct  inquiry  of  such  colleague  as  to  the 
conditions,  is  professional  discourtesy. 

3.  Canvassing  the  clients  of  a  colleague  for  business  is  un- 

professional. 

4.  To  recognize  or  affiliate  with  a  society  that  in  its  charter 

title  assumes  the  words  "  Certified  Public  Accountant," 
without  warrant  of  law  as  to  its  membership,  is  wrong, 
and  gives  countenance  to  an  implied  fraud. 

Publicity. 

1.  No  professional  accountant  should  advertise  or  display  his 

talents  as  a  merchant  does  his  wares. 

2.  Professional  cards   should   show   in   plain   inconspicuous 

type  the  name,  occupation,  and  office  address.  No 
strained  effect  is  consistent  or  dignified. 

3.  The  same  form  of  card  may  be  used  in  publications  of  a 

recognized  standard,  such  as  technical  magazines,  law 
periodicals,  etc. 

4.  It  is  not  good  professional  form  to  solicit  business  through 

trade  journals,  flashy  publications,  programmes  or  the 
daily  press,  especially  under  a  pseudonym  or  publisher's 
index  mark. 

5.  The  use  of  the  public  press  in  discussions  or  essays  on 

matters  of  technical  or  general  interest  is  legitimate. 
6  The  use  of  initials  or  other  insignia  as  an  affix  to  a  prac- 
titioner's name  in  his  business  advertisements  other 
than  such  as  is  recognized  by  statutory  enactment  in 
the  United  States  or  is  authoritatively  recognized  in 
other  countries  is  unprofessional. 


code  of  ethics.  '  383 

Corporations. 

1.  No  member  should  conceal  his  personality  under  a  cor- 

porate name,  either  actual  or  fictitious. 

2.  The  skill  and  knowledge  of  the  profession  is  individual, 

and  cannot  be  transferred  to  a  corporation,  the  accruing 
goodwill  is  otherwise  lost. 

3.  Success  in  any  professional  career  is  a  matter  of  person- 

ality. 

4.  A  corporation  ''  per  se  "  cannot  make  an  audit  which  in  the 

full  intent  of  the  service  is  a  judicial  function. 

5.  A  corporation  is  without  honor,  which  is  the  keystone  of 

the  profession. 

6.  Directors  cannot  direct  in  a  profession  of  which  they  are 

not  members.  It  is  a  prostitution  of  the  financial  stand- 
ing of  the  directors  and  stockholders,  leading  to  unfair 
competition  and  prejudiced  decisions. 

7.  The  ultimate  profit  to  the  lay   stockholder   or  director, 

whether  expressed  tangibly  or  otherwise,  is  an  illegiti- 
mate gain  or  advantage  which  the  profession  cannot 
countenance. 

8.  In  the  case  of  legal  liability  as  the  result  of  negligence  or 

criminal  perversion  of  logical  facts  the  ultimate  respon- 
sibility rests  with  the  practitioner,  notwithstanding  the 
financial  support  and  control  of  outsiders. 

9.  Assurance  of  secrecy  in  affairs  of  clients  of  such  corpora- 

tions cannot  be  taken  seriously. 

10.  The  profession  needs  no  control  or  regulation  from  the 

laity;  it  is  not  an  industry. 

At  the  same  meeting  the  following  addition  to  the  by-laws 
of  the  American  Association  of  Public  Accountants,  pertaining 
to  professional  ethics  was  adopted.  Mr,  Cooper  is  entitled  to 
the  credit  for  this  article  as  with  the  exception  of  rule  5  which 
was  recommended  by  the  Committee  on  Professional  Ethics, 


384  AUDITING. 

of  which  he  was  chairman,  it  was  submitted  by  him  through  the 
Illinois  Society  of  Certified  Public  Accountants: 

Article  VII  of  By-Laws  of  American  Association  of 
Public  Accountants. 

Professional  Ethics. 

The  following  are  declared  to  be  the  fundamental  rules  of 
the  Association:  for  (a)  the  infraction  of  any  part  thereof,  or 
if  (b)  convicted  of  felony  or  misdemeanor,  or  if  (c)  finally 
declared  by  a  court  of  competent  jurisdiction  to  have  com- 
mitted any  fraud,  or  is  (d)  held  by  the  Board  of  Trustees  on 
the  written  complaint  of  any  person  aggrieved,  whether  a  mem- 
ber or  not,  to  have  been  guilty  of  any  act  or  default  discredit- 
able to  the  profession,  or  is  (e)  declared  by  any  competent 
court  or  commission  to  be  insane  or  otherwise  incompetent,  or 
(f)  fails  to  pay  any  subscription,  dues,  assessment,  or  other 
sum  owed  by  him  to  the  Association  under  its  by-laws  within 
three  months  after  such  debt  has  become  due : 

A  member  renders  himself  liable  to  be  expelled  from  the 
Association  or  to  be  suspended  for  a  term  not  exceeding  two 
years  by  resolution  of  the  Board  of  Trustees  sitting  as  a  Trial 
Board. 

Rules. 

1.  No  member  shall  allow  any  person  not  being  either  a 
member  of  the  Association  or  in  partnership  with  him  as  a 
public  accountant,  or  in  his  employ  on  a  salary,  to  practice  in 
his  name  as  a  public  accountant. 

2.  No  member  shall  directly  or  indirectly  allow  or  agree  to 
allow  a  commission,  brokerage,  or  other  participation  by  the 
laity  in  the  fees  or  profits  of  his  (the  member's)  professional 
work. 

3.  No  member  shall  engage  in  any  business  or  occupation 
conjointly  with  that  of  a  public  accountant,  which  in  the  opin- 


PROFESSIONAL  ETHICS.  385 

ion  of  the  Board  of  Trustees  is  incompatible  or  inconsistent 
therewith. 

4.  No  member  shall  certify  to  exhibits,  statements,  sched- 
ules, or  other  form  of  accountancy  work,  the  preparation  of 
which  was  not  carried  on  entirely  under  the  supervision  of 
himself,  a  member  of  his  firm,  one  of  his  staff,  a  member  of 
this  Association  or  of  similar  association  of  good  standing  in 
foreign  countries. 

5.  No  member  shall  in  his  business  advertisements  use  any 
initials  as  an  affix  to  his  name  that  is  not  either  authorized  by 
statutory  enactment  of  this  country  or  by  the  well-known  asso- 
ciations established  for  a  similar  purpose  in  the  British'  Em- 
pire, nor  shall  he  affiHate  or  substantially  recognize  any  society 
that  is  designated  or  in  any  way  sets  itself  out  to  be  a  so-called 
Certified  Public  Accountant  Society,  without  the  State  in  which 
such  society  is  organized  having  the  requisite  statutory  enact- 
ment in  full  force  and  effect. 

At  the  1909  annual  meeting  the  following  additional  rules 
were  adopted : 

6.  No  member  shall  agree  to  perform  accountancy  work 
for  parties  to  commercial  ventures  or  contested  cases,  either 
in  prospect  or  instituted,  payment  of  fee  for  which  is  by  ar- 
rangement based  upon  the  contingency  of  the  results. 

7.  No  member  shall  interfere,  or  in  any  way  take  part  in 
any  effort  looking  to  the  modification,  alteration,  or  amend- 
ment of  any  State  laws  affecting  the  profession  of  account- 
ancy without  the  concurrence  and  co-operation  of  the  society 
or  societies  of  the  State  or  district  concerned,  unless  such 
action  shall  not  violate  any  of  the  fundamental  rules  of  the 
Association. 


APPENDIX  C. 


Report  of  a  Case  bearing  upon  the  question  of  the 
Liability    of   Directors    for    the    payment     of 
Dividends  out  of  Capital  instead  of  Profits,  as 
provided  in  the  Corporation  Laws  of  New  York 
and  New  Jersey. 


Archibald  A.  Hutchinson  and  Victor  K. 
McElheny,  Jr.,  on  Behalf  of  Themselves 
and  All  Other  Stockholders  of  the  American 
Malting  Co.,  Similarly  Situated,  Plaintiffs, 

V. 

Alexander  M.  Curtiss  and  The  American 
Malting  Co.,  Defendants. 

(Supreme  Court,   New  York   Special  Term,   December, 
1904,  92  N.  Y.  Supp.  70.) 

Liability  of  director  of  foreign  corporations  for  making  un- 
authorized dividends — Payment  of  dividends  on  preferred 
stock  must  be  made  from  profits,  not  from  capital — Expecta- 
tion of  future  profits  on  contracts  not  to  be  figured  as  assets — 
Effect  of  absence  of  director  v^hen  such  unauthorized  divi- 
dends declared — Losses  through  payment  of  commissions  on 
sale  of  bonds. 

The  statutes  of  this  State  allow  the  recovery,  from  directors 
of  a  foreign  corporation,  of  dividends  unauthorized  by  the 
laws  under  which  such  corporation  is  organized.  It  is  the 
foreign  statute  that  makes  the  dividends  unauthorized,  but  the 
recovery  is  to  be  had  under  the  New  York  statute. 

386. 


AMERICAN   MALTING  CASE.  387 

No  dividends  can  be  made  except  from  "  surplus  or  net 
profits." 

Contracts,  entered  into  by  a  corporation,  for  future  de- 
liveries of  a  product  not  yet  made  by  it,  from  raw  material 
not  yet  purchased,  cannot  be  taken  as  assets  in  figuring  said 
surplus  or  net  profits.  Dividends  cannot  be  made  on  a  mere 
hope  or  expectation  of  profits. 

Where  raw  material  is  bought  by  weight,  and  after  manu- 
facture is  increased  in  weight  and  value,  the  corporation  is  en- 
titled to  treat  it  as  an  asset  at  its  increased  value. 

A  director,  who  is  not  present  when  an  unauthorized  divi- 
dend is  declared,  is  not  liable  under  the  statute,  even  though 
he  is  present  at  a  subsequent  meeting  when  the  minutes  of  the 
former  meeting  are  ratified. 

A  director,  sued  for  unauthorized  dividends,  cannot  be 
credited  with  the  profits  which  subsequently  accrued  under  a 
change  of  management. 

A  director  is  not  liable  for  commissions,  paid  on  the  sale  of 
bonds  of  a  corporation  which  had  made  unauthorized  divi- 
dends, in  the  absence  of  proof  of  fraud  and  conspiracy  for 
the  defendant's  personal  benefit;  such  loss  is  included  in  the 
loss  caused  by  the  illegal  dividends  which  defendant  must  pay. 

Action  against  director  for  making  unauthorized  dividends. 

Clarke,  /.; 

The  American  Malting  Company  was  organized  under  the 
laws  of  New  Jersey,  September  28,  1897.  It  began  business 
on  October  11,  1897.  On  October  15,  1897,  it  filed  a  copy  of 
its  charter  in  the  office  of  Secretary  of  State  of  New  York  to 
enable  it  to  do  business  in  this  State,  and  received  the  usual 
certificate  for  that  purpose.  The  principal  office  of  the  com- 
pany was  situated  in  the  City  of  New  York,  at  No.  80  Broad- 
way, from  its  organization  until  the  fall  of  1899,  ^"<^  since 
then  it  has  been  situated  continuously  at  East  River  and  Sixty- 


388  AUDITING. 

third  Street,  New  York  City.  The  company  has  had  no  plant 
or  property  in  New  Jersey.  It  has  kept  no  bank  account  there. 
It  had  merely  a  formal,  statutory  office  in  that  State.  Its 
capital  stock  is  $30,000,000,  divided  into  300,000  shares  of 
$100  each,  of  which  144,400  shares  of  preferred  stock  and 
145,000  shares  of  common  stock  have  been  issued.  The  pre- 
ferred stock  is  seven  per  cent,  cumulative,  having  a  preference 
as  to  dividends  only.  The  company  is  engaged  in  the  manu- 
facture and  sale  of  malt.  Its  stock  was  issued  to  promoters 
for  twenty-one  malting  establishments,  situated  in  various 
parts  of  the  United  States,  on  which  they  had  acquired  options, 
and  for  $2,080,000  cash  working  capital.  No  stock  in  trade 
was,  however,  acquired  by  the  issue  of  stock.  As  soon  as  the 
organization  was  effected  the  company  was  compelled  to  pur- 
chase from  the  vendors  of  the  various  malting  plants  their 
stocks  of  barley  and  malt,  for  which  the  company  issued  its 
obligations,  amounting  to  upward  of  $1,600,000.  A  little  over 
two  months  after  the  company  began  business,  and  on  Decem- 
ber 20,  1897,  the  board  of  directors  declared  a  dividend  of  one 
and  three-fourths  per  cent,  to  preferred  stockholders,  payable 
January  15,  1898.  This  amounted  to  $219,450.  Thereafter 
a  dividend  at  the  same  rate  was  declared  and  made  payable  at 
each  of  the  following  dates:  April  15,  1898,  $219,450;  July  15, 
1898,  $219,450;  October  15,  1898,  $219,450;  January  15,  1899, 
$219,450;  April  15,  1899,  $252,700;  July  15,  1899,  $252,700; 
October  15,  1899,  $252,700.  In  all  $1,855,350.  Barely  two 
weeks  after  the  payment  of  the  dividend  of  October  15,  1899, 
and  on  November  2,  1899,  the  minutes  of  the  board  of  directors 
disclosed  its  serious  financial  condition  as  reported  to  said 
board,  viz.,  its  outstanding  obligations  amounted  to  $2,800,000 
in  notes;  that  the  officers  were  unable  to  negotiate  further 
temporary  loans;  that  the  company  needed  additional  work- 
ing capital,  and  that  the  board  authorized  the  sale  of  $4,000,000 
mortgage  bonds  of  the  company.  Said  bonds,  six  per  cent, 
fifteen-year  gold  mortgage  bonds,  were  subsequently  disposed 
of  at  a  discount  of  $400,000.  This  is  an  action  brought  by 
plaintiffs  as  stockholders  on  behalf  of  themselves  and  all  other 


AMERICAN  MALTING  CASE.  389 

stockholders  similarly  situated  against  the  defendant  Curtiss 
as  director  of  the  company  to  compel  him  to  account  for  and 
pay  to  the  company  the  amount  of  the  dividends  declared  and 
paid  as  not  having  been  paid  out  of  the  profits,  but  out  of  the 
capital.  The  board  of  directors  having  upon  demand  refused 
or  neglected  to  bring  suit  in  the  name  of  the  company,  it  was 
joined  as  a  party  defendant.  At  first  the  company  put  in  a 
defense,  but  subsequently,  its  management  having  changed,  it 
obtained  leave  to  file  an  amended  answer  admitting  the  alle- 
gations of  the  complaint  and  joining  in  the  prayer  of  the 
plaintiffs  for  the  relief  demanded.  In  a  similar  action  against 
another  of  the  directors  the  complaint  was  dismissed  upon  the 
trial.  Upon  appeal  the  Appellate  Division  reversed  that 
judgment.  Hutchinson  v.  Stadler,  85  App.  Div.  428.  That 
case  settled  the  law  for  this  court  to  this  extent ;  that  an  action 
could  be  maintained  in  the  courts  of  this  State  against  a  di- 
rector of  a  New  Jersey  corporation  to  recover  the  amount  of 
dividends  declared  in  violation  of  the  laws  of  that  State.  Two 
opinions  were  handed  down,  in  which  the  learned  justices 
arrived  at  the  conclusion  that  the  action  could  be  maintained 
upon  different  grounds.  With  each  of  these  opinions  a  jus- 
tice concurred.  The  fifth  learned  justice  concurred  in  the 
result.  I  cite  this  division  of  opinion  because  this  court  is 
now  called  upon  to  apply  the  law,  as  laid  down  with  this  prac- 
tical embarrassment,  that  while  it  was  the  unanimous  deci- 
sion that  the  action  could  be  maintained,  yet  the  difference  in 
the  grounds  therefor  means  a  difference  of  hundreds  of  thou- 
sands of  dollars  in  the  judgment  I  am  about  to  order.  As 
I  interpret  it  that  case  holds  this  court  has  jurisdiction,  be- 
cause section  twenty-three  of  the  Stock  Corporation  Law  of 
this  State  provides :  "  The  directors  of  a  stock  corporation 
shall  not  make  dividends,  except  from  the  surplus  profits  aris- 
ing from  the  business  of  such  corporation;  nor  divide,  with- 
draw or  in  any  way  pay  to  the  stockholders,  or  any  of  them, 
any  part  of  the  capital  of  such  corporation,  or  reduce  its 
capital  stock,  except  as  authorized  by  law.  In  case  of  any 
violation  of  the  provisions  of  this  section,  the  directors  under 


390  AUDITING. 

whose  administration  the  same  may  have  happened,  except 
those  who  may  have  caused  their  dissent  therefrom  to  be 
entered  at  large  upon  the  minutes  of  such  directors  at  the  time, 
or  were  not  present  when  the  same  happened,  shall  jointly 
and  severally  be  liable  to  such  corporation  and  to  the  credit- 
ors thereof  to  the  full  amount  of  the  capital  of  such  cor- 
poration so  divided,  withdrawn,  paid  out  or  reduced;"  and 
because  section  thirty  of  the  General  Corporation  Law  of  New 
Jersey  provides :  "  No  corporation  shall  make  dividends,  ex- 
cept from  the  surplus  or  net  profits  arising  from  its  business, 
nor  divide,  withdraw  or  in  any  way  pay  to  the  stockholders, 
or  any  of  them,  any  part  of  its  capital  stock,  or  reduce  its 
capital  stock,  except  according  to  this  act,  and  in  case  of  any 
violation  of  the  provisions  of  this  section  the  directors  under 
whose  administration  the  same  may  happen  shall  be  jointly 
and  severally  liable  at  any  time  within  six  years  after  paying 
such  dividends  to  the  corporation  and  to  its  creditors  in  the 
event  of  its  dissolution  or  insolvency  to  the  full  amount  of 
the  dividend  made  or  capital  stock  so  divided,  withdrawn, 
paid  out  or  reduced,  with  interest  on  the  same  from  the  time 
such  liability  accrued;  provided  that  any  director  who  may 
have  been  absent  when  the  same  was  done,  or  who  may  have 
dissented  from  the  act  or  resolution  by  which  the  same  was 
done,  may  exonerate  himself  from  such  liability  by  causing 
his  dissent  to  be  entered  at  large  on  the  minutes  of  the  direc- 
ors  at  the  time  the  same  was  done,  or  forthwith  after  he  shall 
have  notice  of  the  same,  and  by  causing  a  true  copy  of  said 
dissent  to  be  published  within  two  weeks  after  the  same  shall 
have  been  so  entered  in  a  newspaper  published  in  the  county 
where  the  corporation  has  its  principal  office ;"  and  because  sec- 
tion sixty  of  the  Stock  Corporation  Law  of  this  State  pro- 
vides :  "  Except  as  otherwise  provided  in  this  chapter  the  offi- 
cers, directors  and  stockholders  of  a  foreign  stock  corporation 
transacting  business  in  this  State,  except  moneyed  and  rail- 
road corporations,  shall  be  liable  under  the  provisions  of  this 
chapter,  in  the  same  manner  and  to  the  same  extent  as  the 
officers,  directors  and  stockholders  of  a  domestic  corporation 


AMERICAN  MALTING  CASE.  39I 

for:  I.  The  making  of  unauthorized  dividends  .  .  .  Such 
liabiHties  may  be  enforced  in  the  courts  of  this  State,  in  the 
same  manner  as  similar  liabilities  imposed  by  law  upon  the 
officers,  directors  and  stockholders  of  domestic  corporations." 
That  is,  by  virtue  of  the  statutes,  this  State  allows  the  re- 
covery of  dividends  unauthorized  by  the  State  of  New  Jersey 
from  directors  of  a  New  Jersey  corporation  in  the  same  man- 
ner and  to  the  same  extent  as  the  directors  of  a  domestic 
corporation.  That  is,  it  is  the  New  Jersey  statute  which  makes 
the  dividend  unauthorized,  but  the  recovery  is  to  be  had  ac- 
cording to  the  New  York  statute.  What,  then,  is  unauthorized  ? 
"  No  corporation  shall  make  dividends  except  from  the  sur- 
plus or  net  profits  arising  from  its  business."  Net  profits 
are  defined  in  the  Century  Dictionary  as  "  what  remains  as 
the  clear  gain  of  any  business  after  deducting  the  capital  in- 
vested in  the  business,  the  expenses  incurred  in  its  management 
and  the  losses  sustained  by  its  operation."  And  the  controll- 
ing question  of  fact  is,  were  these  dividends  paid  from  "  net 
profits  "  ? 

The  twenty-one  branches,  located  in  many  places  and  in 
different  States,  which  were  actually  engaged  in  the  business 
of  manufacturing  the  malt  from  the  barley,  sent  in  to  the 
general  office  in  New  York  daily,  weekly  and  monthly  state- 
ments in  great  detail  of  their  business.  From  these  state- 
ments branch  books  were  made,  and  from  these  a  general  set 
of  books  was  prepared.  All  of  the  books  and  papers  from  the 
general  office,  which  were  used  in  the  accounting  department, 
were  produced  in  court,  identified  and  marked  in  evidence. 
The  defendant  objects  to  the  summaries  made  up  from  these 
books,  and  from  any  and  all  conclusions  of  fact  to  be  drawn 
from  said  books  and  said  summaries  upon  the  ground  that 
concededly  the  contracts  and  the  contract  books  were  not  pro- 
duced and  were  not  considered.  It  was  in  evidence  that  malt 
was  always  oversold,  that  contracts  for  future  deliveries,  run- 
ning over  many  months,  were  entered  into,  and  the  claim  is 
that  such  contracts  were  required  to  be  taken  into  considera- 


392  AUDITING. 

tion  when  it  came  to  be  determined  whether  any  particular 
dividend  was  warranted  or  not.  Such  claim,  in  my  opinion, 
is  unfounded.  The  law  is  that  "  No  corporation  shall  make 
dividends  except  from  the  surplus  or  net  profits."  These 
contracts  were  to  deliver  at  a  future  time  a  product  not  yet 
made  from  raw  material,  not  yet  purchased,  with  the  aid  of 
labor  not  yet  expended.  The  price  agreed  to  be  paid  at  that 
future  time  had  to  cover  all  the  possible  contingencies  of  the 
market  in  the  meanwhile  and  might  show  a  profit,  and  ran 
the  chance  of  showing  a  loss.  When  the  sales  actually  took 
place  they  were  entered  in  the  books.  But  to  calculate  months 
in  advance  on  the  results  of  the  future  transactions,  and  on 
such  calculations  to  declare  dividends,  was  to  base  such  divi- 
dends on  paper  profits — hoped  for  profits,  future  profits — and 
not  upon  the  surplus  or  net  profits  required  by  law.  It  does 
not  seem  to  me  that  you  can  "  divide,"  that  is,  make  a  divi- 
dend of  a  hope  based  on  an  expectation  of  a  future  delivery 
at  a  favorable  price  of  what  is  not  yet  in  existence,  under  the 
statute.  So  the  objection  to  the  books  upon  that  ground  is  of 
no  weight.  From  the  books  certain  statements  were  made  up 
for  the  aid  of  the  court  upon  different  theories  and  in  differ- 
ent ways.  One  set  of  statements  was  testified  to  be  exactly 
what  the  books  showed,  without  the  change  of  a  figure.  These 
exhibits  are  known  as  lo  P,  lo  Q.  As  to  these  statements 
I  do  not  understand  that  there  is  any  controversy  as  to  the 
accuracy  of  the  figures.  A  second  statement,  known  as  lo  R, 
lo  S,  is  identical  with  the  foregoing,  with  the  elimination  of 
one  entry,  which,  as  a  matter  of  act,  was  eliminated  by  the 
company  itself  some  months  after  its  entry.  There  was  entered 
on  the  books  on  the  31st  of  December,  1898,  an  item  of 
$388,063.36  of  the  anticipated  or  estimated  future  profits  on 
contracts  for  future  deliveries  running  over  many  months. 
This  entry,  for  the  reasons  stated  in  regard  to  the  contracts 
for  future  deliveries,  was  unjustifiable.  The  company  sub- 
sequently removed  this  entry.  The  actual  transactions,  that 
is,  the  deliveries  of  the  malt  called  for  by  the  contracts  and 
the  receipts  in  payment  therefor  being  reported  from  time  to 


AMERICAN   MALTING  CASE.  393 

time  as  they  occurred,  resulting  in  double  credits,  the  cancel- 
lation or  reversal  of  the  entry  was  absolutely  required.  On 
the  other  hand,  I  find  against  the  plaintiffs  in  regard  to  their 
contention  as  to  the  increase  account.  Barley  is  bought  by  the 
bushel  of  forty-eight  pounds.  Malt,  the  manufactured  article 
made  from  barley  by  steeping,  is  dealt  in  by  the  bushel  of 
thirty-four  pounds.  The  process  of  manufacture  produces 
about  fifteen  per  cent,  more  of  malt  by  the  bushel  than  the 
barley  measures  from  which  it  is  produced.  The  amount  of 
this  fifteen  per  cent,  excess  is  reported  from  each  of  the  manu- 
factories month  by  month  as  increase.  Of  course,  this  inr 
crease  has  a  value,  as  it  is  sold  as  malt  at  malt  prices.  For 
the  purpose  of  inventory  the  company  has  ascribed  to  it  the 
value  of  the  barley.  This,  plaintiffs  claim,  is  error,  because 
that  amount  has  already  once  been  charged  to  malt  account, 
and  they  say  this  increase  should  have  no  value  ascribed  to  it 
until  sold  and  delivered,  when  its  proceeds  go  into  the  books 
as  cash.  But  it  certainly  is  an  asset  of  the  company,  and 
as  an  asset  at  inventory  periods,  or  when  it  is  necessary  to 
ascertain  the  actual  condition  of  the  company,  it  must  be 
valued  in  some  way.  As  it  has  always  been  the  custom  in 
the  malting  business  to  treat  it  as  treated  by  this  company,  I 
am  unwilling  to  disregard  that  custom.  The  accounts  upon 
which  I  based  my  conclusions  treated  it  as  this  company  did. 
I  find  that  at  the  time  of  the  declaration  and  payment  of  the 
third  dividend,  July,  1898,  a  deficit  was  caused  thereby  of 
$142,774.59,  and  from  that  time  to  the  end  of  the  period  under 
consideration  none  of  the  dividends  were  paid  out  of  net  pro- 
fits, but  all  were  paid  out  of  capital.  But  it  appears  that  de- 
fendant, Curtiss,  was  not  present  at  the  meeting  on  February 
28,  1899,  when  the  dividend  paid  April  15,  1899,  was  author- 
ized. Under  the  New  York  statute — under  which  we  are  pro- 
ceedings— a  director  who  was  not  present  when  the  dividend 
was  declared  is  not  liable.  The  approval  of  the  minutes  at 
the  following  June  meeting  at  which  he  was  present,  was  only 
the  authentication  of  the  proof  of  what  had  happened  at  the 
previous  meeting.     He  is,  therefore,  not  to  be  held  liable  for 


394  AUDITING. 

that  dividend.  He  is  liable,  in  my  judgment,  as  follows:  For 
dividends  paid  July  15,  1898,  to  the  extent  of  $142,774.59; 
October  15,  1898,  $219,450;  January  15,  1899,  $219,450;  July 
15,  1899,  $252,700;  October  15,  1899,  $252,7ock-$i,o87,074.59, 
with  interest  thereon  from  the  several  dates  of  payment.  As 
the  highest  court  of  New  Jersey,  interpreting  the  law  of  the 
State  under  which  this  company  was  incorporated  held,  "  for 
the  full  protection  of  the  company  the  liability  of  the  directors 
must  be  absolute"  {Applet on  v.  Am.  Malting  Co.),  I  find 
against  the  defendant  upon  his  claim  that  the  accrued  profits 
of  the  company,  made  under  a  changed  management,  can  be 
credited  in  his  favor  against  his  liability.  It  is  claimed  that 
this  is  a  harsh  law.  If  it  were,  such  complaint  should  be  made 
to  the  Legislature  and  not  to  the  court.  It  does  not  seem 
to  me  that  in  these  days  of  great  corporations  and  of  com- 
binations into  one  of  many  corporations  it  is  asking  too  much 
of  directors,  fiduciary  officers  as  they  are,  that  they  should 
obey  the  law  of  their  incorporation,  and  not  bring  their  com- 
panies to  the  verge  of  bankruptcy  and  ruin  by  the  payment  of 
quarterly  dividends  on  preferred  stock  out  of  capital  instead 
of  net  earnings.  As  to  the  second  cause  of  action:  While 
the  allegations  are  profuse  as  to  a  "  wilful,  fraudulent  and 
illegal  conspiracy,"  the  proof  failed  to  establish  that  there  was 
any  such  conspiracy  for  defendant's  personal  benefit.  The 
cases  establishing  the  cause  of  action  pointed  at  in  these  alle- 
gations have  been  where  directors  have  diverted  to  themselves 
for  their  own  benefit  the  property  of  the  company.  The  dam- 
age here  flowed  out  of  the  making  of  the  dividends,  if  any 
there  was.  It  was  alleged  that  the  company  had  to  issue 
bonds,  and  that  the  commissions,  discounts  and  interest  thereon 
amount  to  $650,000,  which,  as  a  waste  of  its  funds,  the  plain- 
tiff seeks  to  recover.  But  as  I  find  that  this  flowed  as  a 
damage  only  from  the  declaration  and  payment  of  the  divi- 
dends I  am  persuaded  by  the  language  of  Mr.  Justice  Hatch 
in  Hutchinson  v.  Stadler  supra  that  it  does  not  under  the  facts 
of  this  case  constitute  a  separate  cause  of  action.  He  says: 
*'  In  point  of  fact  that  statute  of  the  State  of  New  Jersey  upon 


AMERICAN   MALTING  CASE.  395 

this  subject  as  well  as  our  own,  does  little  more  than  lay 
down  a  rule  of  damage  to  be  enforced  against  directors 
for  breach  of  duty.  At  common  law  a  recovery  could  be  had 
for  the  waste  but  the  extent  of  the  recovery  would  depend 
upon  the  damage  sustained  by  the  corporation  and  be  the  sub- 
ject of  proof.  The  statute  measures  the  loss  sustained,  which 
is  usually  the  correct  amount,  and  authorizes  a  recovery  there- 
from of  the  individuals  who  produced  that  result."  It  seems 
to  me  that  any  other  theory  would  result  in  turning  the  amount 
recovered  for  illegal  dividends  into  a  penalty.  The  Court  of 
Errors  and  Appeals  of  New  Jersey  in  this  very  matter,  as 
well  as  our  Appellate  Division,  have  held :  "  The  liability  im- 
posed by  the  statute  is  not  penal  in  its  character.  Its  sole 
purpose  is  not  to  punish,  but  to  provide  for  the  making  of 
compensation  by  wrongdoers  for  the  injury  sustained  by  their 
wrongful  act."  This  alleged  loss  must,  therefore,  be  held  to 
have  been  included  in  that  for  which  the  defendant  is  required 
to  make  compensation  by  paying  into  the  company  an  amount 
equal  to  the  illegal  dividends. 


APPENDIX  D. 


Forms  of  Accounts. 

In  Chapter  VII  mention  was  made  of  the  fact  that  various 
governmental  bodies  had  prescribed  classifications  of  accounts 
and  forms  of  report  for  corporations  coming  within  their  juris- 
diction, and  that  the  American  Association  of  Public  Account- 
ants and  other  bodies  had  also  been  active  in  devising  improved 
forms  for  uniform  use  by  various  undertakings.  Nearly  all  of 
the  forms  now  submitted  are  of  recent  compilation,  and  will 
no  doubt  be  improved  from  time  to  time.  Nevertheless  the 
practitioner  and  student  may  find  suggestions  of  value  in  these 
pages.  Criticisms  for  future  use  will  be  welcomed  by  the 
editor. 

The  source  from  which  each  of  the  forms  has  been  drawn 
is  given.  As  the  forms  of  reports  to  governmental  bodies  are 
usually  quite  voluminous,  including  many  schedules  for  histor- 
ical use  and  much  statistical  data  which  are  not  of  sufficient 
importance  to  warrant  their  reproduction  in  full,  a  selection 
has  been  made  of  those  parts  which  are  of  general  interest  to 
accountants. 

STEAM  RAILROAD  COMPANIES. 
The  fiield  in  which  governmental  regulation  first  took  the 
form  of  actually  prescribing  the  manner  in  which  the  accounts 
themselves  should  be  kept,  as  distinguished  from  the  require- 
ment that  reports  should  be  made  on  a  prescribed  form,  was 
that  of  interstate  common  carriers,  chief  among  which  are 
steam  railroads.  Except  as  noted,  the  following  forms  are 
those  prescribed  by  the  Interstate  Commerce  Commission. 

*Form  1.     Balance  Sheet. 
The  Interstate  Commerce  Commission  has  not  yet  prescribed 
a  standard  form  of  balance  sheet.     The  form  here  submitted  is 


*  For  convenience  the  forms  follow  the  entire  descriptive  matter.    See  pages  411  et  sej. 


APPENDIX  D.  397 

a  modification  of  the  form  of  report  required  to  be  made  by 
steam  railroads  to  the  Commission  for  the  year  ended  30th 
June,  1908. 

This  form  does  not  show  all  the  details  which  it  might  be 
desirable  in  the  case  of  some  companies  to  show.  There  will 
frequently  be  special  items  which  ought  to  be  stated  separately, 
but  they  will  usually  fall  under  one  of  the  general  heads  shown 
on  this  form. 


Form  2.     Statement  of  Capital  Expenditures. 

A  separate  tentative  classification  of  "Additions  and  Better- 
ments "  has  also  been  issued  by  the  Commission,  but  this  is 
not  yet  final  nor  is  its  use  compulsory. 

The  totals  of  this  statement  appear  in  the  Balance  Sheet 
(Form  i)  under  the  caption  "  Road  and  Equipment." 

Form  3.     Income  Account. 

In  describing  the  balances  shown  at  the  various  rests  in  the 
account  the  terms  "  Revenue  "  and  "  Income ''  would  neces- 
sarily become  "  Deficit "  and  "  Lx)ss  "  if  expenditure  exceeded 
income. 

Form  4.     Profit  and  Loss  Account. 

This  is  the  form  prescribed  by  the  Interstate  Commerce 
Commission,  slightly  modified. 

If  the  Income  Account  (Form  3)  for  the  year  shows  a  loss 
instead  of  a  profit,  the  balance  thereof  would  naturally  appear 
on  the  debit  instead  of  the  credit  side  of  the  Profit  and  Loss 
Account.  Similarly,  if  instead  of  having  a  surplus  at  the  date 
of  the  balance  sheet,  the  company  has  a  deficit,  the  balance  of 
the  Profit  and  Loss  Account  would  be  stated  as  a  debit  balance, 
instead  of  a  credit  balance,  as  shown  in  this  form. 


39^  AUDITING. 

Form  5.     Detailed  Statement  of  Operating  Revenues. 
Form  6.     Detailed  Statement  of  Operating  Expenses. 

The  totals  of  these  statements  are  entered  in  the  Income 
Account  (Form  3). 

For  independent  companies  operating  250  miles  or  less  and 
having  annual  operating  revenues  not  exceeding  $1,000,000, 
and  for  terminal  and  switching  companies,  the  Commission  has 
promulgated  a  condensed  classification  of  operating  expenses. 
The  five  general  accounts  are  the  same  for  both  classes  of 
roads,  but  the  116  primary  accounts  of  the  extended  classifica- 
tion are  reduced  to  44  accounts  in  the  condensed  classifica- 
tion. 

Form  7.     Summary  of  Revenues  and  Expenses  of  Outside 
Operations  and  other  Properties. 

This  form  shows  the  diflferent  operations  carried  on  by  rail- 
road companies  which  the  Commission  has  officially  designated 
as  "  outside  operations,"  and  the  revenues  and  expenses  of 
which  are  now  stated  separately  from  those  which  are  directly 
incidental  to  transportation  by  rail. 

The  totals  of  section  "A"  of  this  summary  are  entered  in 
the  Income  Account  (Form  3),  while  the  net  profit  or  loss 
shown  by  section  "  B  "  is  entered  in  the  Profit  and  Loss  Ac- 
count (Form  4). 

Detailed  classifications  of  operating  accounts  have  also  been 
prescribed  by  the  Commission  for  each  class  of  operations  in- 
cluded in  this  form. 

PUBLIC  SERVICE  CORPORATIONS  AND  MUNICIPAL 
INDUSTRIES. 

Attention  has  already  been  directed  to  the  importance  of  the 
subject  of  accounts  pertaining  to  public  service  corporations. 


APPENDIX  D.  399 

Form  8.     Standard  Schedule  of  Revenue  and  Expense  for 
Municipal  Industries  and  Public  Service  Companies. 

This  is  the  form  as  amended  by  a  committee  appointed  by 
the  American  Association  of  Public  Accountants  and  sub- 
mitted at  the  1907  convention  of  the  Association. 

This  is  a  condensed  form  which  is  applicable  to  any  form  of 
public  utility — transportation,  electric  or  gas  lighting,  water 
supply,  telephone,  etc. — and  would  be  supported  by  detailed 
schedules  containing  the  details  pertinent  to  each  particular 
utility. 

It  should  be  of  especial  value  in  comparing  the  operations 
of  different  enterprises,  as  it  is  designed  to  bring  out  very 
clearly  ho\Y  the  items,  the  treatment  of  which  is  more  or  less 
a  matter  of  judgment  (e.  g.,  depreciation),  or  which  for  other 
reasons  may  be  considered  as  "  variables,"  have  been  handled. 

ELECTRIC  RAILWAY  COMPANIES. 

These  forms  are  based  on  the  classification  prescribed  by  the 
Interstate  Commerce  Commission  for  use  from  ist  January, 
1909,  by  electric  railways  subject  to  its  jurisdiction.  In  a  pre- 
liminary letter  the  Commission  stated  that  it  was  working  in 
conjunction  with  the  various  state  bodies  having  jurisdiction 
over  electric  railways.  This  being  so,  the  probability  is  that 
the  classification  of  accounts  promulgated  by  the  Commission 
will  eventually  be  adopted  by  the  various  state  commissions  and 
become  the  uniform  system  of  accounts  for  electric  railways. 
As  noted  in  Chapter  IV,  the  New  York  Public  Service  Com- 
missions have  already  prescribed  classifications  very  similar  in 
their  general  outline  to  the  Interstate  Commerce  Commission 
classification,  though  somewhat  more  elaborate. 

The  form  of  balance  sheet,  income  account  and  profit  and 
loss  account  for  electric  railway  companies  would  differ  only 
in  minor  details  from  those  for  steam  railroad  companies  (see 
Forms  i,  3  and  4),  and  hence  are  not  submitted.    The  classi- 


400  AUDITING. 

fications  of  construction,  earnings  and  operating  expense  ac- 
counts, however,  are  given  in  the  following  forms: 

Form  9.     Classification  of  Expenditures  for 
Road  and  Equipment. 

Form  10.     Statement  of  Operating  Revenues. 

Form  11.     Statement  of  Operating  Expenses. 

Two  condensed  classifications  of  operating  expenses  have 
been  promulgated  for  small  companies,  one  of  58  accounts, 
instead  of  the  full  number  of  88,  for  companies  having  annual 
operating  revenues  of  $250,000  to  $1,000,000,  and  another  of 
36  accounts  for  companies  with  annual  operating  revenues  of 
less  than  $250,000.  The  classifications  of  construction  expen- 
ditures and  operating  revenues  are  the  same,  however,  for  all 
companies. 

ELECTRIC  LIGHT,  HEAT  AND  POWER  COMPANIES 
AND  GAS  COMPANIES. 

The  systems  of  accounts  prescribed  by  the  Public  Service 
Commissions  of  New  York  for  the  corporations  subject  to 
their  jurisdiction  are  the  basis  of  the  forms  shown  herewith. 

i 

Form  12.     Balance  Sheet. 

is  for  a  company  engaged  in  producing  and  supplying  both 
electricity  and  gas.  For  a  company  supplying  only  one  or  the 
other  of  these  commodities,  the  details  under  the  heading  of 
Plant  pertaining  to  that  used  in  either  electric  or  gas  operations 
would  be  eliminated  and  one  of  the  items  of  Material  and  Sup- 
plies under  Current  Assets  would  fall  out;  otherwise  the  bal- 
ance sheet  would  be  unchanged. 

As  the  Commissions  have  not  yet  prescribed  a  definite  form 
of  balance  sheet,  since  promulgating  the  classifications  of  ac- 
counts which  became  effective  ist  January,  1909,  the  form 
herewith  is  a  modification  of  the  form  in  use  by  the  Commis- 


APPENDIX  D.  401 

sion  for  the  Second  District  up  to  this  time.  It  will  be  noticed 
that  the  capital  stock  is  shown  after  the  actual  liabilities  and 
in  juxtaposition  to  the  surplus. 

Form  13.     Income  Account 

is  also  for  company  engaged  in  supplying  both  electricity  and 
gas.  For  a  company  supplying  only  one  or  the  other,  one  of 
the  groups  of  Operating  Revenues  and  Expenses  would  fall  out, 
and  if  no  "  outside  operations  "  are  carried  on  the  group  bear- 
ing that  designation  would  likewise  be  eliminated.  In  other 
respects  the  form  would  be  the  same. 

Form  14.     Statement  01  Corporate  Surplus  Account. 
(Profit  and  Loss.) 

Form  15.     Classification  of  Accounts  for  Electric  Light,  Heat 
and  Power  Companies  ("  Electrical  Corporations"). 

Form  16.     Classification  of  Accounts  for  Gas  Companies. 

Three  condensed  classifications  of  both  electric  and  gas  oper- 
ating expense  accounts  have  been  issued  for  small  companies, 
the  companies  being  divided  into  the  following  classes : 

Gross  Operating  Revenues. .  .$ioo,ocxD  to  $500,000  per  annum 
"  "  "        ...     25,000  to    100,000  " 

"...     less  than      25,000 

WATER  SUPPLY  SYSTEMS. 

In  the  autumn  of  1908  the  Bureau  of  the  Census  published  in 
connection  with  its  report  for  the  year  1906  on  the  "Statistics 
of  Cities  Having  a  Population  of  Over  30,000,"  an  appendix 
dealing  with  the  subject  of  "  Uniform  Accounts  and  Reports 
of  Water-supply  Systems."  In  addition  to  presenting  the  re- 
sults of  an  exhaustive  study  of  the  subject  by  Dr.  L.  G. 
Powers,  Chief  Statistician  of  the  Bureau  (in  which  he  had  the 
co-operation  of  Mr.  Moses  N.  Baker,  Associate  Editor  of  the 
Engineering  Nezvs,  and  conferred  with  a  committee  of  the 


402  AUDITING. 

American  Association  of  Public  Accountants,  as  well  as  with 
other  organizations)  a  comprehensive  scheme  of  uniform  ac- 
counts for  water-supply  systems  is  submitted. 

Emphasis  is  laid  on  the  fact  that  "  uniform  accounts  (are) 
the  only  basis  for  comparable  statistics  "  and  that  "  questions 
of  municipal  ownership  and  of  municipal  control  over  water 
and  other  public  utility  enterprises  are  demanding  more  per- 
fect, as  well  as  uniform,  accounting  for  these  enterprises." 

Any  one  having  occasion  to  deal  with  the  accounts  of  water- 
supply  systems  should  procure  the  publication  referred  to,  from 
which  the  annexed  forms  are  reproduced.  The  statement  is 
made  that  "  the  water  supply  schedules  which  the  Bureau  of 
the  Census  presents  herewith  for  constructive  criticism  result 
from  an  attempt  to  set  forth  in  logical  and  functional  order  all 
the  more  pertinent  facts  relating  to  the  construction  and  opera- 
tion of  municipal  water-supply  systems.  If  the  schedules  are 
too  extensive  and  too  detailed,  it  is  because  the  aim  has  been 
to  make  them  ideally  inclusive  with  the  idea  that  they  may  be 
shortened,  if  necessary,  to  make  them  practicable  for  actual 
use.     .     .     . 

"...     five  orders  of  accounts  are  suggested,  viz. : 

1.  Summary  or  controlling  accounts. 

2.  General  accounts,  indicated  by  Roman  numerals. 

3.  Sub-general  accounts,  indicated  by  capital  letters. 

4.  Primary  accounts,  indicated  by  Arabic  numerals. 

5.  Sub-primary  accounts,  indicated  by  small  letters. 

The  summary,  general  and  subgeneral  accounts  are  arranged 
for  the  purpose  of  grouping  the  different  items  of  income  and 
expenditure,  and  of  property  and  equipment  under  certain 
general  heads,  so  as  to  admit  of  their  presentation  in  a  con- 
densed form  in  publishing  reports  and  statistical  summaries. 
The  subgeneral  accounts  may  also  be  used  as  the  only,  or  at 
least  the  principal,  accounts  of  small  water-supply  enterprises, 
with  a  gross  annual  income  not  exceeding  $25,000,  whose 
operations  do  not  warrant  greater  detail  in  accounting.     The 


APPENDIX  D.  403 

primary  accounts  are  provided  for  the  use  of  the  larger  sys- 
tems— those  having  a  gross  annual  income  of  $25,000  or  over. 
Cities  and  corporations  operating  such  systems  may  also  use 
subprimary  accounts  in  whatever  detail  they  may  desire.  No 
suggestion  is  here  made  for  such  accounts  other  than  that  they 
should  be  so  arranged  as  to  be  subordinate  to  the  primary  ac- 
counts mentioned  in  the  tentative  scheme  of  accounts." 

Form  17.     Tentative  Classification  of  Operation  Accounts. 

Form  18.     Allocation  Accounts. 

Form  19.     Property  Accounts. 

Attention  is  also  called  to  the  value  of  combining  the  infor- 
mation obtained  from  the  financial  accounts  with  that  presented 
by  the  physical  statistics,  or,  in  other  words,  cost  accounting. 

Form  20.     Is  a  Suggestion  for  a  Condensed  Analytical  Cost 
Accounting  Summary. 

The  following  forms  comprise  the  Proposed  Census  Sched- 
ule for  Securing  Uniform  Reports  of  the  Transactions  and 
Condition  of  Water-Supply  Enterprises: 

Form  21.     Part  I,  Financial  Transactions  for  the  Year. 

Form  22.     Part  II,  Summary  of  the  Cost  of  W^ater-Supply 
System  and  of  Its  Extensions,  Additions,  and  Renewals. 

Form  23.     Part  III,  Condensed  Balance  Sheet. 

It  will  be  seen  that  Part  I  is  a  statement  of  earnings  and 
operating  expenses  and  a  profit  and  loss  account.  Exception 
may  be  taken  to  including  in  gross  income  from,  and  expenses 
of,  operation  such  items  as  earnings  and  expenses  of  invested 
funds  and  interest  on  cash  balances  in  bank.  These  should  be 
shown  under  a  separate  heading,  say,  Other  Income,  in  the 
profit  and  loss  account.  It  would  also  be  well  to  segregate 
the  earnings  and  expenses  of  accessory  enterprises,  the  opera- 
tion of  which  by  a  water-supply  company  is  optional.     In  other 


404  AUDITING. 

words,  in  stating  the  profit  and  loss  or  income  account  the 
gross  earnings  and  the  operating  expenses  directly  incident 
thereto,  and  the  gross  profit  or  net  earnings  resulting  from,  the 
supplying  of  water,  should  be  shown  separate  from  accessory 
enterprises  (similar  to  the  "  outside  operations  '*  of  railroads) 
and  miscellaneous  income,  otherwise  the  basis  of  comparison 
between  different  systems  is  lost. 

It  should  be  noted  that  the  system  of  accounts  proposed 
by  the  Census  Bureau  is  for  use  by  both  municipalities  and 
private  corporations.  The  principal  points  of  divergence  would 
be  in  the  "  allocation  "  section  of  the  income  or  profit  and  loss 
accounts  and  the  "  proprietary  interests  "  section  of  the  balance 
sheet. 

BANKS. 

Form  24.     Form  of  Report  Required  to  Be  Made  by  National 
Banks  to  the  Comptroller  of  the  Currency 

on  the  occasion  of  a  call  by  him  for  the  condition  of  national 
banks  throughout  the  country.  Section  521 1  of  the  Revised 
Statutes  of  the  United  States  provides  that  the  Comptroller 
must  make  at  least  five  such  calls,  as  a  day  already  past,  dur- 
ing each  year. 

Unlike  the  procedure  in  the  regulation  of  railroads,  the  gov- 
ernment, in  its  supervision  of  national  banks,  does  not  prescribe 
a  certain  classification  of  accounts.  Common  sense,  however, 
would  suggest  the  keeping  of  the  accounts  in  such  a  way  as  to 
facilitate  the  ready  preparation  of  the  reports  called  for. 

The  forms  of  report  for  state  banks,  trust  companies  and 
savings  banks  vary  with  the  states  in  which  the  institutions 
are  located  and  sometimes  contain  special  features ;  e.  g.,  the 
law  of  the  State  of  New  York  requires  state  banks  and  trust 
companies  to  state  their  deposit  liabilities  in  two  classes,  "  pre- 
ferred deposits,"  the  payment  of  which,  in  case  of  insolvency, 
is  preferred  by  law  or  otherwise  over  other  deposits,  and 
"  other  deposits." 


APPENDIX  D.  405 

BUILDING  AND  LOAN  ASSOCIATIONS. 

Aside  from  the  apportionment  of  profits  among  the  various 
series  of  stock,  the  stating  of  building  association  accounts  in- 
volves no  unusual  features.  The  accounts  usually  published 
are  in  one  respect  subject  to  the  same  criticism  as  those  of  life 
insurance  companies,  in  that  they  seldom  contain  a  profit  and 
loss  account  but  only  a  statement  of  receipts  and  disbursements. 
The  latter  is,  however,  a  valuable  statement  and  should  not 
be  omitted  even  when  a  profit  and  loss  account  is  submitted,  as 
it  shows,  among  other  things,  the  volume  of  transactions  which 
could  otherwise  be  ascertained  only  by  a  laborious  analysis 
and  comparison  of  the  current  balance  sheet  and  the  one  pre- 
ceding. 

Building  and  loan  associations  are  chartered  by  the  states, 
and  are  usually  subject  to  the  supervision  of  the  state  banking 
department.  The  form  of  report  required  to  be  made  varies 
in  the  different  states.  The  annexed  forms  are  a  combination 
of  the  best  ones  in  use. 

Form  25.     Balance  Sheet. 

Form  26.     Profit  and  Loss  Account. 

Form  27.     Receipts  and  Disbursements. 

Form  28.     Statement  of  Share  Capital. 

Some  associations,  though  not  many,  accompany  the  last 
statement  by  a  tabulated  exhibit  of  the  dues  paid  in  and 
profits  per  share  for  each  unmatured  series  in  each  year  of  its 
existence,  and  the  percentage  of  the  profit  earned  each  year. 
Combined  with  the  statements  above  enumerated,  this  makes 
a  very  complete  exhibit  of  the  condition  and  earnings  of  an 
association. 

INSURANCE  COMPANIES. 

Why  insurance  companies  have  continued  to  transact  busi- 
ness with  such  primitive  accounting  systems  as  most  of  them 
have,  or  have  had  until  recently,  is  difficult  to  understand.     It 


406  AUDITING. 

may  be  due  in  part  to  the  fact  that  the  forms  of  reports  re- 
quired by  the  state  departments  having  supervision  over  insur- 
ance companies  have  encouraged,  if  not  actually  approved,  un- 
scientific methods  of  accounting.  The  distinction  between 
"  ledger  "  and  "  non-ledger  "  assets  is  an  instance  in  point ;  the 
incomplete  cash  account  which  is  published  in  lieu  of  a  proper 
income  and  expenditure  account  is  another. 

At  the  time  of  the  New  York  life  insurance  investigation 
several  years  ago,  the  matter  of  requiring  better  accounting 
methods  on  the  part  of  the  companies  and  the  submission  of 
reports  prepared  along  proper  lines  received  the  attention  of 
the  American  Association  of  Public  Accountants,  a  committee 
of  which,  acting  jointly  with  a  committee  of  the  New  York 
Society  of  Certified  Public  Accountants,  appeared  before  the 
Armstrong  Committee  of  the  New  York  State  Legislature  and 
presented  the  necessity  for  reform  in  accounting  methods  in  a 
very  forcible  manner. 

A  report  of  the  Committee's  criticisms  and  suggestions  ap- 
peared in  the  April,  1906,  Journal  of  Accountancy. 

The  following  forms  of  account,  copies  of  which  are  an- 
nexed, were  suggested: 

Form  29.     Balance  Sheet. 

Form  30.     Assurance  Account  and  Surplus  Account. 

Form  31.     Analysis  of  Agency  Expenses. 

Form  32.     Analysis  of  Administration  and  General  Expenses. 

It  is  to  be  regretted  that  the  forms  suggested  were  not 
adopted,  as  they  are  far  superior  to  the  forms  ordinarily  used, 
and  give  in  a  concise  way  the  information  which  is  of  vital 
interest  to  the  policy  or  stock  holder.  By  means  of  supplemen- 
tal schedules  they  can  be  amplified  to  any  extent  desired. 

To  show  the  contrast  between  these  forms  and  those  in  use 
by  the  state  departments,  the  principal  schedules  in  the  volu- 
minous report  called  for  by  the  Insurance  Department  of  New 


APPENDIX  D.  407 

York  (which  is  the  form  in  use  by  most,  if  not  all,  of  the  other 
states)  are  shown  herewith  as  Form  33.  It  will  be  noticed  that 
an  analysis  of  the  increase  or  decrease  in  the  surplus  is  now 
called  for,  though  this  form  is  very  cumbersome;  this  may 
be  ascribed  in  part  at  least  to  the  incomplete  accounts  from 
which  it  must  be  prepared.  The  editor  does  not  recollect  hav- 
ing ever  seen  this  exhibit  included  in  any  of  the  statements 
published  by  the  companies  for  the  information  of  their  policy- 
holders. 

While  these  model  forms  are  primarily  for  life  companies, 
the  balance  sheet,  and  assurance  and  surplus  accounts  can,  by 
proper  modification,  be  adapted  for  use  by  fire  and  other  com- 
panies. 

MANUFACTURING  AND  MERCANTILE 
ENTERPRISES. 

Here  is  where  the  greatest  diversity  of  form  is  naturally 
to  be  expected.  While  detailed  forms  suitable  for  any  and 
every  business  of  this  character  cannot  be  prepared,  yet  the 
essentials  of  a  balance  sheet  and  income  account  can  be  pointed 
out.  The  annexed  forms  are  submitted  more  for  this  purpose 
than  with  any  thought  that  they  can  be  used  without  modifica- 
tion. 

Form  34.     Form  of  Balance  Sheet 

prescribed  by  the  English  Companies  Act,  1862  (Table  "A"). 
(The  asset  and  liability  sides  have  been  transposed  to  accord 
with  the  general  American  practice.) 

There  is  much  to  be  said  in  favor  of  this  form,  and  despite 
the  fact  that  it  had  been  in  use  for  forty-six  years,  and  hence 
might  be  thought  to  require  reconsideration,  no  change  was 
made  therein  at  the  time  of  passing  the  1908  Companies  Act. 

Form  35.     Form  of  Balance  Sheet 
submitted  by  Mr.  G.  S.  Pitt  in  a  paper  on  "Forms  of  Pub- 
lished Accounts  of  Trading  Concerns  and  Some  Observations 


408  AUDITING. 

on  Their  Audit,"  read  at  the  1908  Autumnal  Conference  of  the 
Society  of  Incorporated  Accountants  and  Auditors.  In  the 
words  of  Mr.  Pitt :  "It  is  not  suggested  that  this  form  is  suit- 
able for  general  adoption.  It  has  been  prepared  with  a  view 
to  illustrate  the  manner  in  which  particular  items  should  be 
stated."  Mr.  Pitt  laid  special  emphasis  on  the  importance  of 
showing  "  the  liquid  assets  added  up  in  total  on  the  one  side, 
and  cash  liabilities  added  up  in  total  on  the  other  side." 

Mr.  Pitt's  paper  and  a  report  of  the  discussion  which  fol- 
lowed its  presentation  will  be  found  in  The  Accountant  of  3rd 
October,  1908. 

As  with  the  preceding  forms,  the  asset  and  liability  sides  are 
transposed  on  the  form  herein. 

Form  36.     Form  01  Balance  Sheet 

recommended  to  the  Company  Law  Committee  by  the  Society 
of  Incorporated  Accountants  and  Auditors  in  1906. 

In  the  form  herewith  the  asset  and  liability  sides  have  been 
transposed  and  some  other  slight  modifications  made  for  the 
convenience  of  American  practitioners  and  students. 

Form  37.     Balance  Sheet  for  Manufacturing  Companies. 

This  is  a  form  combining  the  best  features  of  published 
American  reports.  This  form  can  also  be  used  for  a  consoli- 
dated balance  sheet  by  entering  in  the  Capital  Stock  section 
an  item  of  Stock  of  Subsidiary  Companies  Not  Owned  by 
Holding  Company,  if  any,  and  including  the  proportion  of  sur- 
plus of  subsidiary  companies  accruing  to  the  holders  of  such 
stock,  among  the  liabilities. 

Form  38.     Balance  Sheet  for  Trading  Firm. 

A  very  simple  form  which  can  readily  be  amplified,  as  to 
detail,  to  any  extent  desired. 


APPENDIX  D.  409 

Form  39.     Profit  and  Loss  Account. 

Submitted  by  Mr.  A.  Lowes  Dickinson,  C.P.A.,  F.C.A.,  in 
his  paper  on  "  The  Profits  of  a  Corporation,'*  which  was  read 
at  the  Congress  of  Accountants  in  1904.  This  form  "already 
in  fairly  general  use,  is  submitted  as  the  most  complete  short 
form  and  by  means  of  exhibits  it  is  capable  of  amplification 
to  any  extent  desirable." 

Form  40.     Profit  and  Loss  Account  for  Trading  Firm. 
A  simple  form  also  capable  of  amplification  to  any  extent. 

Form  41.     Standard  Form  of  Borrowers'  Statement. 

This  form  has  been  officially  adopted  by  the  New  York 
State  Bankers'  Association  and  is  believed  to  be  the  most  com- 
plete "  short  "  form  in  use. 

The  question  "  Have  the  books  been  audited  by  a  Certified 
Public  Accountant  ?  "  was  suggested  some  years  ago  by  Mr. 
James  G.  Cannon,  Vice-President  of  the  Fourth  National  Bank 
of  New  York,  one  of  the  foremost  bankers  of  the  country. 

Mr.  Cannon's  influence  has  resulted  in  a  more  general  ap- 
preciation by  bankers  of  the  services  of  public  accountants. 

If  bankers  would  uniformly  insist  on  the  certification  of  bor- 
rowers' statements  by  professional  accountants  they  would  save 
millions  of  dollars  through  the  elimination  of  doubtful  loans. 

MUNICIPAL  REPORTS. 

The  movement  for  uniform  municipal  reports,  which  has 
received  the  attention  of  such  organizations  as  the  National 
Municipal  League,  as  well  as  of  accountants,  economists  and 
others,  for  a  considerable  number  of  years  past,  has  made 
especial  progress  during  the  past  few  years. 

Whereas  it  was  at  one  time  seriously  questioned  whether 
there  could  be  uniformity  in  either  the  accounts  or  reports 
of  municipalities,  it  is  now  recognized  that  there  can  be  uni- 
formity in  reports,  and  that  the  keynote  "  is  the  classification 
of  the  receipts  and  payments  (or  revenue  and  expenses)  of 


4IO  AUDITING. 

cities  upon  a  common  basis  along  functional  lines,  so  that  the 
relative  cost  of  government  and  of  any  governmental  function 
of  one  city  can  be  compared  within  reasonable  limits  with  the 
corresponding  costs  for  other  cities."  (L.  G.  Powers,  U.  S. 
Census  Bureau.) 

Form.  42.     Classification  of  Receipts  and  Payments  Used  by 
the  United  States  Bureau  of  the  Census 

in  preparing  its  reports  on  the  statistics  of  cities ;  this  classifica- 
tion has  been  unanimously  recommended  by  the  National 
Municipal  League  and  League  of  American  Municipalities,  the 
latter  organization  including  many  Canadian  cities. 

The  movement  for  municipal  balance  sheets  has  not  yet  re- 
sulted in  any  considerable  number  of  cities  publishing  such 
statements,  and  it  will  doubtless  require  an  extensive  educa- 
tional campaign  before  it  will  be  the  general  custom  for 
American  municipalities  to  issue  balance  sheets  prepared  on 
scientific  lines.     It  is,  however,  sure  to  come. 


THE-. RAILROAD  COMPANY 

BALANCE  SHEET 19 

ASSETS: 


Road  and  Equipment: 

Cost  of  Road 

Cost  of  Equipment 

General  Expenditures . 


Lands  Owned 

Other  Permanent  Investments  (Specify) , 

Securitiis  Owned: 

Stocks 

Bonds 


Advances     to    Controlled    or    Affiliated 

Companies 

Current  Assets: 

Materials  and  Supplies 

Bills  Receivable 

Traffic  Balances  due  from  other  Companies. 

Due  from  Agents 

Miscellaneous  Accounts  Receivable 

Cash 

Sinking  and  Special  Fund  Assets: 

(Specify) 


LIABILITIES: 

Capital  Stock 

(If  more  than  one  class,  specify) 


Funded  Debt: 

(Specify,  stating  nature,  rate  of  interest, 

and   due  date) 

Due  Controlled  or  Affiliated  Companies  . 
Current  Liabilities: 

Bills  Payable 

Audited  Vouchers 

Pay  Rolls 

Traffic  Balances  due  other  Companies  — 

Accrued  Taxes 

Accrued  Interest  on  Funded  Debts 

Accrued  Rentals 

Miscellaneous 


Sinking  and  Special  Funds  : 
(Specify) 


Profit  and  Loss  (undivided  profits) . 


(Form  1) 
411 


(STEAM  RAILROAD) 


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(STEAM  RAILROAD) 


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413 


(STEAM   RAILROAD) 

INCOME   ACCOUNT 

Year  ended 19. . . 

Operating  Income: 
Rail  Operations : 

Operating  Revenues $ . 

Operating  Expenses 


Net  Operating  Revenue.  .       $. . . . 
Outside  Operations: 

Revenues $ .  . . . 

Expenses .... 


Net  Revenue. 


Total  Net  Revenue.  .       $. 
Taxes  Accrued 


Operating  Income.  .  $. 

Other  Income: 
*Other  Rents — Credits: 

(a)  Hire  of  Equipment — Balance $. . . . 

(b)  Joint  Facilities .... 

(c)  Miscellaneous  Rents ....$.... 


*Separately  Operated  Properties — Profit 

Dividends  Declared  on  Stocks  Owned  or  Controlled. . . 
Interest  Accrued  on  Funded  Debt  Owned  or  Controlled . 
Interest  on  Other  Securities,  Loans,  and  Accounts .... 
Miscellaneous  Income , 


Total  Other  Income. 


Gross  Corporate  Income $. 

Deductions  From  Gross  Corporate  Income: 

fRents  Accrued  for  Lease  of  Other  roads $ . 

Interest  Accrued  on  Funded  Debt 

Other  Interest 

Sinking  Funds  Chargeable  to  Income 

Other  Deductions 

Total  Deductions  From  Gross  Corporate  Income  ....       $ . 

Net  Corporate  Income $. 

Disposition  of  Net  Corporate  Income: 
Dividends  Declared: 

(a)  On  Preferred  Stock $ 

(b)  On  Common  Stock .... 

(c)  On  Other  Securities .... 

.  $.... 

Additions  and  Betterments  Charged  to  Income .... 

Appropriations  to  Reserves .... 

Miscellaneous : 


(specify) 


Balance  for  Year  Carried  Forward 
To  Credit  of  Profit  and  Loss 


*If  "  Other  Rents"  shows  a  debit  balance  or  "Separately  Operated  Properties' 
loss,  they  are  entered  under  "Deductions  from  Gross  Corporate  Income." 

t"  Rents  Accrued  from  Lease  of  Roads"  are  entered  under  "  Other  Income." 

(Form  3) 
414 


(STEAM   RAILROAD) 

PROFIT  AND  LOSS  ACCOUNT 
Year  ended 19. . . 

/  CREDIT : 

Balance, (beginning  date) $. 

Balance  for  Year  Brought  Forward  from  Income  Accoimt 

♦Other  Properties — Profit 

Additions  for  year: 

(specify)  $ 


DEBIT: 


Deductions  for  Year: 
(specify) 


Dividends  Declared  out  of  Surplus: 

(a)  On  Preferred  Stock $. 

(b)  On  Common  Stock 

(c)  On  Other  Securities 


Balance  Credit — (ending  date) $. 


♦If  "  other  Properties"  show  a  loss  it  is,  of  course,  entered  under  "Debit. 

(FOEM  4) 


415 


(STEAM  RAILROAD) 

OPERATING  REVENUES 

Year  ended 19 . . . 

Revenue  From  Transportation: 

Freight  Revenue $ . 

Passenger  Revenue $ 

Excess  Baggage  Revenue 

Parlor  and  Chair  Car  Revenue 

Mail  Revenue 

Express  Revenue 

Milk  Revenue  (on  Passenger  Trains) 

Other  Passenger  Train  Revenue 

Total  Passenger  Service  Train  Revenue 

Switching  Revenue 

Special  Service  Train  Revenue 

Miscellaneous  Transportation  Revenue 


Total  Revenue  from  Transportation $ . 

Revenue  from  Operations  Other  Than 
Transportation  : 

Station  and  Train  Privileges $ 

Parcel-Room  Receipts 

Storage — Freight 

Storage — Baggage 

Car  Service 

Telegraph  Service 

Rents  of  Buildings  and  Other  Property 

Miscellaneous 

Total  Revenue  from  Operations  Other 
Than  Transportation 


Total  Operating  Revenues $ . 

(FOEM  5) 
416 


(STEAM  RAILROAD) 

r  OPERATING  EXPENSES 

Year  ended 19. . 

Ratio  to 

Ratio  to  Total 

Gen'l  Acc't     Operating 

(Per  cent)       Expenses 

(Per  cent) 

Maintenance  of  Wat  and  Structures: 

I,  Superintendence  $ 

Ballast 

Ties 

Rails 

Other  Track  Material 

Roadway  and  Track 

Removal  of  Snow,  Sand  and  Ice 

Tunnels 

Bridges,  Trestles,  and  Culverts 

Over  and  Under  Grade  Crossings 

Grade  Cross  'gs,  Fences,  Ct  'le  G  'ds,  and  Signs  ; 

Snow  and  Sand  Fences  and  Snow  Sheds 

Signals  and  Interlocking  Plants 

Telegraph  and  Telephone  Lines 

Electric  Power  Transmission 

Buildings,  Fixtures,  and  Grounds 

Docks  and  Wharves 

Roadway  Tools  and  Supplies 

Injuries  to  Persons 

Stationery  and  Printing 

Other  Expenses  

Total  of  Foregoing  Accounts  $ 

Maintaining  Joint  Tracks,  Yards,   and 
Other  Facilities — Dr. , 

Maintaining  Joint  Tracks,   Yards,   and 
Other  Facilities — Cr., 


Total — Maintenance  of  Way  and 
Structures, 

Maintenance  of  Equipment: 
Superintendence 
Steam  Locomotives — Repairs 
Steam  Locomotives — Renewals 
Steam  Locomotives — Depreciation 
Electric  Locomotives — Repairs 
Electric  Locomotives — Renewals 
Electric  Locomotives — Depreciation 
Passenger-Train  Cars — Repairs 
Passenger-Train  Cars — Renewals 
Pat5senger-Train  Cars — Depreciation 
Freight-Train  Cars — Repairs 
Freight-Train  Cars — Renewals 
Freight-Train  Cars — Depreciation 
Electric  Equipment  of  Cars — Repairs 
Electric  Equipment  of  Cars — Renewals 
Elec.  Equipm't  of  Cars — Depreciation 
Floating  Eq\iipment — Repairs 
Floating  Equipment — Renewals 
Floating  Equipment — Depreciation 
Work  Equipment — Repairs 
Work  Equipment — Renewals 
Work  Equipment — Depreciation 
Shop  Machinery  and  Tools 
Power  Plant  Equipment 

M.  E,  Expenses  carried  forward 

(Form  6) 
417 


(STEAM  RAILROAD) 

OPERATING  EXPENSES— Continued 


Maintenance  of  Equipment — Continued  : 

Brought]_forward        J 
Injuries  to  Persons 
Stationery  and  Printing 
Other  Expenses 

Total  of  Foregoing  Accounts,  ! 

Maintaining  Joint  Equipment  at  Termi- 
nals— Dr. 
Maintaining  Joint  Equipment  at  Termi- 
nals— Cr. 

Total — ^Maintenance  of  Equipment  i 

Traffic  Expenses:  I 

Superintendence 
Outside  Agencies 
Advertising 
Traffic  Associations 
Fast  Freight  Lines 

Industrial    and   Immigration    Bureaus 
Stationery  and  Printing 
Other  Expenses 

Total — Traffic  Expenses 

Transportation  Expenses:  i 

Superintendence 
Dispatching  Trains 
Station  Employees 

Weighing  and  Car-Service  Associations 
Coal  and  Ore  Docks 
Station  Supplies  and  Expenses 
Yardmasters  and  their  Clerks 
Yard  Conductors  and  Brakemen 
Yard  Switch  and  Signal  Tenders 
Yard  Supplies  and  Expenses 
Yard  Enginemen 
Enginehouse  Expenses — Yard 
Fuel  for  Yard  Locomotives 
Water  for  Yard  Locomotives 
Lubricants  for  Yard  Locomotives 
Other  Supplies  for  Yard  Locomotives 

Total  of  Last  Fifteen  Accounts  : 

Operating  Joint  Yards  and  Terminals — Dr. 
Operating  Joint  Yards  and  Terminals — Cr. 

Total — Station  and  Yard  Expenses        I 
Motormen 

Road  Enginemen  I 

Enginehouse  Expenses — Road 
Fuel  for  Road  Locomotives 
Water  for  Road  Locomotives 
Lubricants  for  Road  Locomotives 
Other  Supplies  for  Road  Locomotives 

Transportation  Expenses  carried 

forward  I 

Form  6 — Continued 

418 


Ratio  to 
IRatioto     m  Total 
{General     |Operating 
^Account      Expenses  \ 
(Percent.)    (Per Cent.) 


(STEAM  RAILROAD.) 
OPERATING  EXPENSES— Continued. 

Ratio  to       Ratio  to 
General     T'talOper- 

Expenses    atingE*p. 

(Percent)    (Percent) 
Transportation  Expenses — Continued:! 

Brought  forward        $ 
Operating  Power  Plants 
Purchased  Power 
Road  Trainmen 
Train  Supplies  and  Expenses 
Interlockers,  Block  and  Other  Signals — 

Operation 
Crossing  Flagmen  and  Gatemen 
Drawbridge  Operation 
Clearing  Wrecks 

Telegraph  and  Telephone — Operation 
Operating  Floating  Equipment 
Express  Service 
Stationery  and  Printing 
Other  Expenses 
Loss  and  Damage — Freight 
Loss  and  Damage — Baggage 
Damage  to  Property 
Damage  to  Stock  on  Right  of  Way 

Injuries  to  Persons  

Total  of  Last  Twenty-five  Accounts        $ 
Oper't'g  Joint  Tracks  and  Facilities — Dr. 
Oper't'g  Joint  Tracks  and  Facilities — Cr. 

Total — ^Movement  Expenses,        $ 

Total — ^Transportation  Expenses,        $ 


General  Expenses 

Salaries  and  Expenses  of  General  Officers 
Salaries    and   Expenses   of   Clerks   and 

Attendants 
General  Office  Supplies  and  Expenses 
Law  Expenses 
Insurance 

Rehef  Department  Expenses 
Pensions 

Stationery  and  Printing 
Other  Expenses 

Total  of  Foregoing  Accounts, 
General    Administration    Joint    Tracks, 

Yards,     and     Terminals — Dr., 
General  Administration  Joint    Tracks, 

Yards,  and  Terminals — Cr. , 

Total — General  Expenses 

Recapitulation  of  Expenses  : 

Maintenance  of  Way  and  Structures 
Maintenance  of  Equipment 
Traffic  Expenses 
Transportation  Expenses 
General  Expenses 

Total — Operating  Expenses, 

Ratio  of  Operating  Expenses  to  Operating 
Revenues, per    cent. 

(Form  6 — Concluded) 
419 


(STEAM  RAILROAD) 


SUMMARY    OF    REVENUES    AND    EXPENSES    OF    OUTSIDE 
OPERATIONS    AND    OTHER    PROPERTIES 

Year  ended 19 

A.    OUTSIDE  OPERATIONS. 

Net 
Revenue 
or 
Designation.  Revenues  Expenses    Deficit 

Boat  Lines  $  $  $ 

Ferry  Lines 

Harbor  Terminal  Transfers 

Electric  Railways 

Express  Lines 

Cab  and  Omnibus  Service 

Sleeping-Car  Service 

Parlor  and  Chair-Car  Service 

Dining  and  Special  Car  Service 

Electric  Light  and  Power  Plants 

Gas-Producing  Plants 

Canals 

Grain  Elevators 

Stock  Yards 

Conmiercial  Telegraph  and  Telephone  Lines 

Hotels  and  Restaurants 

Amusement  Parks  and  Resorts 

Coal  Storage  Plants 

Cold  Storage  Plants 

Commercial  Ice  Supply  Plants 

Public  Toll-Bridge  Service 

Miscellaneous: 


Total 


B.  OTHER  PROPERTIES. 

Income 
or 
Designation.  Revenues  Expenses     Taxes        Loss 


Total,        $ 


(Form  7) 


420 


STANDARD  SCHEDULE  OF  REVENUE  AND  EXPENSE 

(Income  and  Expenditure) 

For  Municipal  Industries  and  Public  Service  Corporations 

revenue  from  operating. 

Gross  Earnings  from  Public  Services $ 

Gross  Earnings  from  Private  Consumers $ 

Gross  Earnings  from  By-Products,  etc $ 


Total $ 

Deduct  Rebates,  Refunds,  Discounts,  etc $- 

Total  Revenue  from  Operating $ 

Expense  of  Operating 

1.  Expense  of  Manufacture 

Operation $ 

Maintenance $ 

Product  Purchased  (Gas,  etc.) $ 

2.  Expense  of  Distribution 

Operation $ 

Maintenance $ 

3.  General  Expense  (Salaries,  Office  Supplies 

and  Expenses) $ 

Total  (1,  2  and  3) $ 

4.  Taxes  (Real  Estate  and  Other) $ 

5.  Franchise  Taxes  (paid  or  accrued  annually 

or  otherwise) $ 

6.  Rentals  (Leaseholds,  etc.) $ 

7.  Insurance  (Fire,  Accident  and  Fiduciary) . .  $ 

8.  Damages    (including  Extraordinary  Legal 

and  Other  Expenses  and  Losses) $ 

9.  Guaranty  (Bad  Debts  Written  Off  and  Re- 

serve for  Doubtful  Accounts) $ 

10.     Depreciation  (Deterioration  Written  Off  and 

Reserve  for  Estimated  Depreciation) . .  $ 

Total  Expense  of  Operating $ 


a.  Net  Revenue  from  Operating  (or  Deficiency) $ 

b.  Other  Revenue,  or  Income,  net  (from  Sources  Other  Than 

Operating) $ 

c.  Appropriations  for  Operating,  Provided  by  the  Munici- 

pality from  General  Funds $ 

Total  Available  Income $ 

Disposition  of  Available  Income 

11.  Interest  on  Funded  and  Floating  Debts $ 

Remainder  of  Available  Income $  ' 

12.  Reserved  for  Sinking  Funds $ 

13.  Reserved  for  Amortization  Funds $ 

14.  Reserved  for  Other  Funds $ 

Total  Reserves $ 

15.  Dividends  (Private  Plants) $ 

16.  Appropriation  to  General  City  Funds  (Pub- 

lic Plants) $ 

Total  disposition  of  Available  Income $ 

Credit  (or  Debit)  balance  transferable  to  "Surplus"        $~ 

Note:     The  various  items  in  this  condensed  statement  (particularly  expense  items 
1   2  and  3)  should  be  supported  by  detailed  schedules. 

(FOKM  8) 
421 


CLASSIFICATION  OF  EXPENDITURES  FOR  ROAD  AND  EQUIP- 
MENT OF  ELECTRIC  RAILWAYS 

I.    Road — 

1.  Engineering  and  Superintendence 

2.  Right  of  Way 

3.  Other  Land  Used  in  Electric  Railway  Operations 

4.  Grading 
6.  Ballast 

6.  Ties 

7.  Rails,  Rail  Fastenings,  and  Joints 

8.  Special  Work 

9.  Underground  Construction 

10.  Paving 

11.  Track  Laying  and  Surfacing 

12.  Roadway  Tools 

13.  Tunnels 

14.  Elevated  Structures  and  Foundations 
16.  Bridges,  Trestles,  and  Culverts 

16.  Crossings,  Fences,  Cattle  Guards,  and  Signs 

17.  Interlocking  and  other  Signal  Apparatus 

18.  Telegraph  and  Telephone  Lines 

19.  Poles  and  Fixtures 

20.  Underground  Conduits 

21.  Transmission  System 

22.  Distribution  System 

23.  Dams,  Canals,  and  Pipe  Lines 

24.  Power-Plant  Buildings 

25.  Substation  Buildings 

26.  General  Office  Buildings 

27.  Shops  and  Carhouses 

28.  Stations,  Waiting  Rooms,  and  Miscellaneous  Buildings 

29.  Docks  and  Wharves 

30.  Power-Plant  Equipment 

31.  Substation  Equipment 

32.  Shop  Equipment 

33.  Park  and  Resort  Property 

34.  Cost  of  Road  Purchased 


II.    Equipment — 

35.  Cars 

36.  Locomotives 

37.  Electric  Equipment  of  Cars 

38.  Other  Rail  Equipment 

39.  Miscellaneous  Equipment 


III.    General  Expenditures — 

40.  Law  Expenses 

41.  Interest 

42.  Injuries  and  Damages 

43.  Taxes 

44.  Miscellaneous 

(Form  9) 

422] 


(ELECTRIC  RAILWAY) 

OPERATING  REVENUES. 
Year  ended 19 . . 

Revenue  from  Transportation: 

Passenger  Revenue $ 

Baggage  Revenue 

Parlor,  Chair  and  Special  Car  Revenue 

Mail  Revenue 

Express  Revenue 

Milk  Revenue 

Freight  Revenue 

Switching  Revenue 

Miscellaneous  Transportation  Revenue 

Total, $. 

Revenue  from  Operations  Other  than  Transportation: 

Station  and  Car  Privileges $ 

Parcel-Room  Receipts 

Storage 

Car  Service 

Telegraph  and  Telephone  Service 

Rents  of  Tracks  and  Terminals 

Rents  of  Equipment 

Rents  of  Buildings  and  Other  Property 

Power 

Miscellaneous 

Total, 


Total  Operating  Revenues $. 


(Form  10) 
423 


OPERATING  EXPENSES 

Year  ended 19 . . .  Ratio  to 

Ratio  to        ^  Total 
Gen'l  Acc't     Operating 

Way  and  Structures  :  (Per  cent)      f^^^^^f^ 

Sup'tendence  of  Way  and  Structures      $ 

Ballast 

Ties 

Rails 

Rail  Fastenings  and  Joints 

Special  Work 

Underground  Construction 

Roadway  and  Track  Labor 

Paving 

Misc.  R'dway  and  Track  Expenses 

Cleaning  and  Sanding  Track 

Removal  of  Snow,  Ice  and  Sand 

Tunnels 

Elevated  Structures  and  Foundations 

Bridges,  Trestles,  and  Culverts 

Cross 'gs,  Fences,  Cattle  G'ds,  and  Signs 

Signal  and  Interlocking  Systems 

Telephone  and  Telegraph  Systems 

Other  Miscellaneous  Way  Expenses 

Poles  and  Fixtures 

Underground  Conduits 

Transmission  System 

Distribution  System 

Miscellaneous  Electric  Line  Expenses 

Buildings  and  Structures 

Depreciation  of  Way  and  Structures 

Foreg'g  Way  and  Structure  Exp.  $ 

Other  Operations — Dr., 

Other  Operations — Cr., 

Total — ^Way  and  Structures,  $ 


Equipment: 

Superintendence  of  Equipment 

Power-Plant  Equipment 

Substation  Equipment 

Passenger  and  Combination  Cars 

Freight,  Express,  and  Mail  Cars 

Locomotives 

Service  Cars 

Electric  Equipment  of  Cars 

Electric  Equipment  of  Locomotives 

Shop  Machinery  and  Tools 

Shop  Expenses 

Horses  and  Vehicles 

Other  Misc.  Equipment  Expenses 

Depreciation  of  Equipment 

Foregoing  Equipment  Expenses 
Others  Operations — Dr., 
Other  Operations — Cr., 

Total — ^Equipment 

Traffic: 

Superintendence  and  Solicitation 
Advertising 

Miscellaneous  Traffic  Expenses 
Total  Traffic, 


(Form  11) 
424 


(ELECTRIC  RAILWAY) 

OPERATING  EXPENSES— Continued 

Ratio  to 

Ratio  to        Total  | 

General      Operating 

Account     Expenses 

(Percent)  (PerCent) 

Conducting  Transportation: 

Superintendence  of  Transportation ...         $ 

Group  I — Power 
Power-Plant  Employees 
Substation  Employees 
Fuel  for  Power 
Water  for  Power 
Lubricants  for  Power 
Miscellaneous  Power-Plant     Supplies 

and  Expenses 
Substation  Supplies  and  Expenses 
Power  Purchased 
Power  Exchanged — Balance, 


Foregoing  Conducting  Transporta- 
tion Expenses 
Other  Operations — Dr., 
Other  Operations — Cr., 

Group  II    Operation  of  Cars 
Passenger     Conductors,     Motormen, 

and  Trainmen 
Freight     and    Express    Conductors, 

Motormen  and  Trainmen 
Miscellaneous  Car-Service  Employees 
Miscellaneous  Car-Service  Expenses 
Station  Employees 
Station  Expenses 
Carhouse  Employees 
Carhouse  Expenses 
Operation  of  Signal  and  Interlocking 

Systems 
Operation  of  Telephone  and  Telegraph 

Systems 
Express  and  Freight  Collections  and 

DeUvery 
Loss  and  Damage 
Other  Transportation  Expenses 

Total— Conducting  Transportation 


General  and  Miscellaneous: 
Salaries  and  Expenses  of  General 

Officers 
Salaries    and    Expenses    of   General 

Office  Clerks 
General  Office  SuppHes  and  Expenses 
Law  Expenses 

Rehef  Department  Expenses 
Pensions 
Miscellaneous  General  Expenses 

Foregoing  General  and  Miscellaneous 
Expenses,  forward 


(Form  11 — Continued) 
426 


(ELECTRIC  RAILWAY) 

OPERATING  EXPENSES— €oncluded 

Ratio  to 
Ratio  to  Total 

General      Operating 
Account      Expenses 
(Per  Cent)    (Per  Cent) 
General  and  Misc.  Exp.,  forward 
Other  Operations — ^Dr., 
Other  Operations — Cr., 


Total — General  and  Miscellaneous 
Undistributed  Accounts: 

Note:  Carriers  are  at  liberty  to  distribute 
items  covered  by  the  following  accounts,  but 
all  reports  to  the  Commission  must  agree  with 
accounts  which  are  prescribed. 

Injuries  and  Damages 

Insurance 

Stationery  and  Printing 

Store  Expenses 

Stable  Expenses 

Rent  of  Tracks  and  Terminals 

Rent  of  Equipment 


Total 


Recapitulation  of  Expenses: 
Way  and  Structures 
Equipment 
Traffic 

Conducting  Transportation 
General  and  Miscellaneous 


Total  Operating  Expenses 
Ratio  of  Operating  Expenses  to  Operating  Revenues^per  cent). 

(Form  11 — Concluded) 


426 


THE GAS  AND  ELECTRIC  COMPANY 

BALANCE  SHEET 19 

ASSETS: 
Franchises  and  Plant: 

Organization $ . 

Electric:  Franchises $ 

Land  Devoted  to  Operations 

Plant  and  Equipment 


Gas:  Franchises 

Land  Devoted  to  Operations. 
Plant  and  Equipment 


Outside  Operations. 


Investments: 

Funded  Debt  of  Other  Corporations $. 

Stocks  of  Other  Corporations 

Advances  to  *Subsidiaiy  and  AflaUated  Cor- 
porations  

Other  Investments 


Special  Deposits 

Prepayments 

Suspense 

Current  Assets: 

Materials  and  Supplies,  Electric. 

Materials  and  Supplies,  Gas 

Bills  Receivable 

Accounts  Receivable 

Cash 

Other  Current  Assets 


LIABILITIES: 
Funded  Debt: 

(Specify,  stating  nature,  rate  of  interest  and  due  date) 


Due  *Subsidiary  and  Affiliated  Companies 

Current  Liabilities: 

Bills  Payable S. 

Accounts  Payable 

Interest  on  Funded  Debt 

Interest  on  Floating  Debt 

Taxes 

Consumers'  Deposits,  Electric 

Consumers'  Deposits,  Gas 

Miscellaneous 


Reserves  : 

(Specify) $. 


Capital  Stock: 
(If  more  than  one  class  specify) . 
Corporate  Surplus 


*0r  "Controlling" 

(FOBM  12) 

427 


(GAS  AND  ELECTRIC  COMPANY) 

INCOME  ACCOUNT 

YEAR  ENDED 19 

Operating  Income: 
Electric  Operations: 

Gross  Operating  Revenues $ 

Operating  Expenses $ 

Taxes 

Uncollectible  Bills 

Income  from  Electric  Operations  $ , 

Gas  Operations: 

Gross  Operating  Revenues $ 

Operating  Expenses $ 

Taxes 

Uncollectible  Bills 

Income  from  Gas  Operations 

Outside  Operations: 

Gross     Revenues     from     Outside 

Operations $ 

Operating  Expenses $ 

Taxes 

Uncollectible  Bills 

Income  from  Outside  Operations  

Total  Operating  Income $ 

Non-Operating  Income: 

Other  Rents — Credits $ 

Interest  Accrued  on  Bonds  Owned 

or  Controlled 

Interest  on  Other  Securities,  Loans 

and  Accounts 

Dividends  on  Stocks  Owned  or  Con- 
trolled   

♦Separately  Operated  Properties — 

Profit 

Miscellaneous  Income 

Total  Non-Operating  Income. .  $ 

Gross  Income  Applicable  to  

Corporate  and  Leased  Pro- 
perties    I 

Deductions  from  Gross  Income: 
Interest  accrued  on  Funded  Debt 

and  Debenture  Stocks $ 

Other  Interest  Deductions 

fRents  Accrued  for  Lease  of  Other 

Electric  Plant  or  Equipment 

fRents  Accrued  for  Lease  of  Other 

Gas  Plant  or  Equipment 

Other  Rents  Accrued — Debits 

Sinking  Funds  Chargeable  to  In- 
come   

Guaranties  of  Periodic  Payments. .  

Other  Contractual  Deductions * 

Amortization  Chargeable  to  Income  

Total  Deductions  from  Gross  

Income 

Net  Corporate  Income  Trans- 
ferred to  Credit  of  Corpo- 
rate Surplus $ 

♦Loss  on  separately  operated  properties  would  be  entered  under  "Deductions  from 
Gross  Income." 

fRents  accrued  from  plant  or  equipment  leased  would  be  entered  tmder  "Non-operat- 
ing Income." 

(Form  13) 

428 


(GAS  AND  ELECTRIC  COMPANY) 


CORPORATE  SURPLUS  ACCOUNT 
CREDITS: 

Balance (beginning  date) S. 

Balance  transferred  from  Income  Account : 

Bad  Debts  Collected 

Other  Additions  to  Surplus: 

(Specify) 


DEBITS: 


Dividends  Declared: 
On  Preferred  Stock . 
On  CJommon  Stock. . 
On  Other  Securities. 


Expenses  elsewhere  unprovided  for 

Amortization  elsewhere  unprovided  for 

Appropriations  to  Reserves 

Gifts  to  Controlled  Corporations 

Other  Appropriations 

Bad  Debts  written  off 

Other  Deductions  from  Surplus: 

(Specify) 

Balance (closing  date). 

(Form  14) 


429 


LIST  OF  ACCOUNTS 

Prescribed  by  New  York  Public  Service-^Commission 
(2nd  District) 

FOR 

Electric  Light,  Heat  and  Power  Companies 
(Effective  1st  January,  1909) 

SCHEDULE  A:  BALANCE  SHEET  OR  INDICANT  ACCOUNTS. 

Fixed  Capital: 

Fixed  Capital,  December  31,  1908 

Land  Devoted  to  Electric  Operations 

Organization 

Franchises  (Electric) 

Patent-rights  (Electric) 

Other  Intangible  Electric  Capital 

General  Structures 

General  Equipment 

Dams,  Canals,  and  Pipe  Lines 

Power  Plant  Buildings 

Furnaces,  Boilers,  and  Accessories 

Steam  Engines 

Turbines  and  Water-wheels 

Gas  Producers  and  Accessories 

Gas  Engines 

Electric  Generators 

Accessory  Electric  Power  Equipment 

Miscellaneous  Power  Plant  Equipment 

Substation  Buildings 

Substation  Equipment 

Poles  and  Fixtures 

Underground  Conduits 

Transmission  System 

Distribution  System 

Line  Transformers  and  Devices 

Electric  Services 

Electric  Meters 

Electric  Meter  Installation 

Municipal  Street  Lighting  System  (Electric) 

Commercial  Arc  Lamps 

Glower  Lamps 

Electric  Motors  and  Heaters 

Electric  Tools  and  Implements 

Electric  Laboratory  Equipment 

Other  Tangible  Electric  Capital 

Engineering  and  Superintendence 

Law  Expenditures  During  Construction 

Injuries  During  Construction 

Taxes  During  Construction 

Miscellaneous  Construction  Expenditures 

Interest  During  Construction 

l»and  in  other  Departments 

Franchises  in  Other  Departments 

Patent-rights  in  Other  Departments 

Other  Intangible  Capital  in  Other  Departments 

Tangible  Capital  in  Other  Departments 

(Form  15) 

430 


ACCOUNTS  FOR  ELECTRIC  COMPANIES— Continued 

Floating  Capital: 
Materials  and  Supplies 
Cash 

Bills  Receivable 
Accounts  Receivable 
Interest  and  Dividends  Receivable 
Other  Current  Assets 

Investments: 
♦Investments 

Special  Deposits  : 

Coupon  Special  Deposits 
Dividend  Special  Deposits 
Other  Special  Deposits 

Prepayment  Accounts: 
Prepaid  Taxes 
Prepaid  Insurance 
Prepaid  Rents 
Other  Prepayments 

Suspense  Accounts: 

Unamortized  Debt|Discount  and  Expense 
Other  Suspense 

Re-Acquired  Securities: 
Re-acquired  Securities 

Debt: 
Funded  (Separate  sub-account  for  each  class) 
Unfunded: 

Taxes  Accrued 

Receiver's  Certificates 

Judgments  Unpaid 

Interest  Accrued 

Dividends  Declared 

Bills  Payable 

Consumers'  Deposits — Electric 

Other  Accounts  Payable 

Other  Unfunded  Debt 


Permanent 

Premiums  on  Stock 
Other  Permanent  Reserves 

♦Defined  as  "all  properties  acquired  not  for  use  in  present  operations,  but  as  a  means 
of  obtaining  or  exercising  control  over  other  corporations,  or  for  income  to  be  derived 
therefronri,  or  for  a  rise  in  value,  or  for  devotion  to  future  operations  at  a  time  when  it  seems 
probable  that  they  cannot  be  so  advantageously  acquired  as  at  the  time  of  actual  acqui- 
eition." 

(Form  15 — Continued) 

431 


(ELECTRIC  RAILWAY) 
ACCOUNTS  FOR  ELECTRIC  COMPANIES.— Continued 

Reserves — Continued: 
Temporary: 

Contractual 

Non-contractual 
Required: 

Accrued  Amortization  of  Capital 

Unamortized  Premium  on  Debt 

Other  Required  Reserves 
Optional: 

Casualties  and  Insurance  Reserve 

Other  Optional  Reserves 

Stocks: 

Stocks  (separate  sub-account  for  each  class) 


SCHEDULE  B:    INCOME  ACCOUNT. 

Operating  Revenues: 

Municipal  Street  Lighting — ^Arc 

Municipal  Street  Lighting — Incandescent 

Lighting  Municipal  Buildings — Electric 

Municipal  Heat  and  Power — Electric 

Miscellaneous  Electric  Revenue — Municipal 

Commercial  Flat  Rate  Lighting 

Commercial  Flat  Rate  Power 

Commercial  Metered  Lighting 

Commercial  Metered  Power 

Railroad  Corporations 

Other  Electrical  Corporations 

Rent  of  Electric  Meters 

Rent  of  Electric  Appliances 

Electric  Merchandise  and  Jobbing  Revenue 

Sale  of  By-Products 

Joint  Electric  Rent  Revenue 

Break-down  Service 

Other  Miscellaneous  Electric  Revenue 


OPERATING  EXPENSES. 

I.     Production  Expenses: 

Station  Superintendence  and  Care 

Boiler  Labor 

Producer  Labor 

Engine  Labor 

Electric  Labor 

Fuel  for  Steam 

Fuel  for  Producer  Gas 

Water  for  Steam  Power  and  Gas 

Water  for  Hydraulic  Power 

Lubricants  for  Power 

Production  Supplies 

Station  Expense 

Repairs  of  Power  Plant  Buildings 

Repairs  of  Furnaces  and  Boilers 

Repairs  of  Boiler  Apparatus 

(Form  15 — Continued) 
432 


ACCOUNTS  FOR  ELECTRIC  COMPANIES— Continued 

Repairs  of  Steam  Accessories 

Repairs  of  Reciprocating  Engines 

Repairs  of  Steam  Turbines 

Repairs  of  Other  Steam  Engine  Equipment 

Repairs  of  Dams,  Canals,  and  Pipe  Lines 

Repairs  of  Turbines  and  Water-wheels 

Repairs  of  Gas  Producers  and  Accessories 

Repairs  of  Gas  Engines 

Repairs  of  Electric  Generators 

Repairs  of  Accessory  Electric  Equipment 

Repairs  of  Station  Tools  and  Implements 

Repairs  of  Miscellaneous  Station  Equipment 

Steam  from  Other  Sources 

Power  Gas  from  Other  Sources 

Electric  Energy  from  Other  Sources 

II.  Transmission  Expenses: 
Transmission  Subway  Rent 
Transmission  Pole  and  Fixture  Repairs 
Transmission  Underground  Conduit  Repairs 
Overhead  Transmission  System  Repairs 
Underground  Transmission  System  Repairs 
Substation  Labor 

Substation  Supplies  and  Expenses 
Repairs  of  Substation  Buildings 
Repairs  of  Substation  Equipment 

III.  Electric  Storage  Expenses: 
Storage  Battery  Labor 

Storage  Battery  Supplies 

Storage  Battery  Renewals 

Repairs  of  Storage  Battery  Accessories 

IV.  Distribution  Expenses: 
Electric  Distribution  Superintendence 
Electric  Distribution  Maps  and  Records 
Electric  Distribution  Office  Expense 

Setting  and  Removing  Meters  and  Transformers 

Distribution  Subway  Rent 

Distribution  Pole  and  Fixture  Repairs 

Distribution  Underground  Conduit  Repairs 

Overhead  Distribution  System  Repairs 

Edison  Tube  System  Repairs 

Other  Underground  Distribution  System  Repairs 

Repairs  of  Electric  Services 

Repairs  of  Transformers 

Electric  Meter  Operation 

Electric  Meter  Repairs 

(Form  15 — Continued) 
433 


ACCOUNTS  FOR  ELECTRIC  COMPANIES  -Continued 

V.  Utilization  Expenses: 
Commercial  Arc  Labor 
Commercial  Arc  Supplies 
Commercial  Arc  Repairs 
Commercial  Incandescent  Installation 
Commercial  Incandescent  Renewals 
Inspection  of  Consumers'  Premises 
Repairs  of  Consumers'  Installations 
Municipal  Street  Arc  Labor 
Municipal  Street  Arc  Supplies 
Municipal  Street  Arc  Repairs 
Municipal  Street  Incandescent  Installation 
Municipal  Street  Incandescent  Renewals 
Municipal  Street  Incandescent  Repairs 

VI.  Commercial  Expenses: 
Commercial  Administration — Electric 
Promotion  Office  Expense — Electric 
Advertising — ^Electric 
Canvassing  and  Soliciting — Electric 
Promotion  Wiring  and  Devices 


VII.     General  and  Miscellaneous  Expenses: 
Salaries  and  Expenses  of  General  Officers 
Salaries  and  Expenses  of  General  Office^Clerks 
General  Office  Supplies  and  Expenses 
General  Law  Expenses 
Miscellaneous  General  Expenses 
Insurance 

Relief  Department  Expenses 
Pensions 

Electric  Franchise  Requirements 
General  Amortization — Electric 
Electric  Expenses  Transferred — Cr. 
Joint  Operating  Expense — Cr. 
Accidents  and  Damages 
Law  Expenses  Connected  withT)amages 
General  Stationery  and  Printing 
Store  Expenses 
Stable  Expenses 

Undistributed  Adjustments — Balance 
Duplicate  Electric  Charges — Cr. 


Taxes: 
Taxes 
Uncollectible  Electric  Bills 

(Form  15 — Continued) 
434 


ACCOUNTS  FOR  ELECTRIC  COMPANIES— Continued 

Non-Operating  Revenues: 

Rent  Accrued  from  Lease  of  Electric^Plant 

Miscellaneous  Rent  Revenues 

Interest  Revenues 

Dividend  Revenues 

Profits  from  Operations'of  Others 

Miscellaneous  Non-operating  Revenues 

Non-Operating  Revenue  Deductions: 

a.  Rent  Expense 

b.  Interest  Expense 

c.  Dividend  Expense 

d.  Others'  Operations  Expense 

e.  Miscellaneous  Non-Operating  Expense 

f.  Non-Operating  Taxes 

g.  Uncollectible  Non-operating  Revenues 

Income  Deductions: 
Interest  Deductions 
Rent  for  Lease  of  Other  Electric  Plant 
Joint  Facility  Rents 
Miscellaneous  Rent  Deductions 
Sinking  Fund  Accruals 
Guaranties  of  Periodic  Payments 
Loss  on  Operations  of  Others 
Other  Contractual  Deductions  from  Income 
Amortization  of  Landed  Capital 
Amortization  of  Debt,  Discount  and  Expense 
Amortization  of  Premium  on  Debt — Cr. 

Appropriation  Accounts: 
Bad  Debts  Collected 
Other  Additions  to  Surplus 
Expenses  Elsewhere  Unprovided  for 
Dividends  on  Outstanding  Stocks 
Amortization  Elsewhere  Unprovided^for 
Appropriations  to  Reserves 
Gifts  to  Controlled  Corporations 
Other  Appropriations 
Bad  Debts  Written  Off 
Other  Deductions  from  Surplus 

(Form  15 — Concluded) 


435 


List  of  A(X0UNTS 
Prescribed  by  New  York  Public  Service  Commission  (2nd  District) 

FOR 

Gas  Companies 
(Effective  1st  January,  1909) 

SCHEDULE  A:  BALANCE  SHEET  OR  INDICANT  ACCOUNTS 

Fixed  Capital: 
Fixed  Capital,  December  31,  1908 
Land  Devoted  to  Gas  Operations 
Organization 
Franchises  (Gas) 
Patent-rights  (Gas) 
Other  Intangible  Gas  Capital 
General  Structures 
General  Equipment 
Works  and  Station  Structures 
Holders 

Furnaces,  Boilers,  and  Accessories 
Steam  Engines 
Gas  Engines 

Miscellaneous  Power  Plant  Equipment 
Benches  and  Retorts 
Water  Gas  Sets  and  Accessories 
Purification  Apparatus 
Accessory  Equipment  at  Works 
Trunk  Lines  and  Mains 
Gas  Services 
Gas  Meters 

Gas  Meter  Installation 
Municipal  Street  Lighting  Fixtures^(Gas) 
Gas  Engines  and  Appliances 
Gas  Tools  and  Implements 
Gas  Laboratory  Equipment 
Other  Tangible  Gas  Capital 
Engineering  and  Supenntendence] 
Law  Expenditures  During  Construction 
Injuries  During  Construction 
Taxes  During  Construction 
Miscellaneous  Construction  Expenditures 
Interest  During  Construction 
Land  in  Other  Departments 
Franchises  in  Other  Departments 
Patent-rights  in  Other  Departments 
Other  Intan^ble  Capital  in  Other  Departmentsi 
Tangible  Capital  in  Other  Departments 

Floating^Capital  : 
Materials  and  Supplies 
Cash 

Bills  Receivable 
Accounts  Receivable 
Interest  and  Dividends  Receivable 
Other  Current  Assets 

(Form  16) 
4S6 


ACCOUNTS  FOR  GAS  COMPANIES— Continued 

Investments: 
Investments 

Special  Deposits: 

Coupon  Special  Deposits 
Dividend  Special  Deposits 
Other  Special  Deposits] 

Prepayments: 
Prepaid  Taxes 
Prepaid  Insurance 
Prepaid  Rents 
Other  Prepayments 

Suspense  Accounts: 
Unamortized  Debt  Discount'and^Expense 
Other  Suspense 

Re-acquired  Securities: 
Re-acquired  Securities 


Debt: 

Fimded  (separate  sub-account^for]eacb  class) 
Unfunded: 

Taxes  Accrued 

Receiver's  Certificates 

Judgments  Unpaid 

Interest  Accrued 

Dividends  Declared 

Bills  Payable 

Consumers'  Deposits — Gas 

Other  Accoimts  Payable 

Other  Unfunded  Debt 


Reserves: 
Permanent : 

Premiums  on  Stocks 

Other  Permanent  Reserves 
Temporary: 

Contractual 

Non-contractual 
Required: 

Accrued  Amortization  of  Capital 

Unamortized  Premium  on  Debt 

Other  Required  Reserves 
Optional: 

Casualties  and  Insurance  Reserve 

Other  Optional  Reserves 

Stocks: 
Stocks  (separate  sub-account  for  each  class) 

(Form  16 — Continued) 


437 


ACCOUNTS  FOR  GAS  COMPANIES--Continued 
SCHEDXJLE  B:  INCOME  ACCOUNT 

Operating  Revenues: 

Municipal  Street  Lighting — Gas 

Lighting  Municipal  Buildings — Gas 

Municipal  Heat  and  Power— Gas 

Miscellaneous  Gas  Revenue — Municipal 

Prepaid  Gas 

Commercial  Metered  Lighting — Gas 

Commercial  Heat  and  Power — Gas 

Other  Gas  Corporations 

Commissions  on  Others'  Gas 

Rent  of  Gas  Appliances 

Gas,  Merchandise,  and  Jobbing  Revenue 

Sale  of  Residuals  and  By-Products 

Joint  Gas  Rent  Revenue 

Other  Miscellaneous  Gas  Revenue 


Operating  Expenses: 

T.  Production  Expenses: 

Works  Superintendence 

Boiler  House  Labor 

Retort  House  Labor 

Generator  House  Labor 

Purifier  House  Labor 

Miscellaneous  Labor  at  Works 

Boiler  Fuel 

Water 

Fuel  Under  Retorts 

Coal  Carbonized 

Coal  Gas  Enric.er 

Generator  Fuel 

Water  Gas  Oil 

Purification  Supplies 

Miscellaneous  Works  Expense 

Repairs  of  Works  and  Station  Structures 

Repairs  of  Furnaces,  Boilers,  and  Accessories 

Repairs  of  Steam  Engines 

Repairs  of  Gas  Engines 

Repairs  of  Miscellaneous  Power  Plant  Equipment 

Repairs  of  Benches  and  Retorts 

Repairs  of  Water  Gas  Sets  and  Accessories 

Repairs  of  Purification  Apparatus 

Repairs  of  Holders 

Repairs  of  Miscellaneous  Equipment 

Repairs  of  Works  Tools 

Gas  Storage 

Gas  from  Other  Sources 


II.  Transmission  and  Distribution  Expenses: 

Transmission  Pumping 
Distribution  Superintendence 
Distribution  Supplies  and  Expenses 
Gas  Meter  and  Installation  Work 

(Form  16 — Continued) 
438 


ACCOUNTS  FOR  GAS  COMPANIES— Continued 

Work  on  Consumers'  Premises 
Repairs  of  Gas  Mains 
Repairs  of  Gas  Services 
Repairs  of  Gas  Meters 
Repairs  of  Distribution  Tools 
Repairs  of  Gas  Appliances 

III.  Municipal  Street  Lighting  Expenses: 
Street  Lamp  Operating 

Street  Lamp  Repairs 

IV.  Commercial  Expenses: 
Commercial  Administration — Gas 
Promotion  Office  Expenses — Gas 
Advertising — Gas 
Canvassing  and  Soliciting — Gas 

V.  General  and  Miscellaneous  Expenses: 
Salaries  of  General  Officers 

Salaries  of  General  Office  Clerks 

General  Office  Supplies  and  Incidental  Expenses 

General  Law  Expenses 

Miscellaneous  General  Expenses 

Insurance 

Relief  Department  Expenses 

Pensions 

Gas  Franchise  Requirements 

Residuals  Expense 

General  Amortization — Gas 

Gas  Expenses  Transferred — Cr. 

Joint  Operating  Expense 

Accidents  and  Damages 

Law  Expenses  Connected  with  Damages 

General  Stationery  and  Printing 

Store  Expenses 

Stable  Expenses 

Undistributed  Adjustments — Balance 

Duplicate  Gas  Charges — Cr. 

Taxes: 
Taxes 
Uncollectible  Gas  Bills 

Non-Operating  Revenues: 

Rent  Accrued  from  Lease  of  Gas  Plant 

Miscellaneous  Rent  Revenues 

Interest  Revenues 

Dividend  Revenues 

Profits  from  Operations  of  Others 

Miscellaneous  Non-Operating  Revenues 

(Form  16 — Continued) 
439 


ACCOUNTS  FOR  GAS  COMPANIES— Continued 

Non-Operating  Revenue  Deductions  : 

a.  Rent  Expense 

b.  Interest  Expense 

c.  Dividend  Expense 

d.  Others'  Operations  Expense 

e.  Miscellaneous  Non-Operating  Expense 

f.  Non-Operating  Taxes 

g.  Uncollectible  Non-operating  Revenues 

Income  Deductions: 
Interest  Deductions 
Rent  for  Lease  of  Other  Gas  Plant 
Other  Rent  Deductions 

f.  Joint  Facihty  Rents 

g.  Miscellaneous  Rent  Deductions 
Sinking  Fund  Accruals 
Guaranties  of  Periodic  Payments 
Loss  on  Operations  of  Others 

Other  Contractual  Deductions  from  Income 
Amortization  of  Landed  Capital 
Amortization  of  Debt  Discount  and  Expense 
Amortization  of  Premium  on  Debt — Cr. 

Appropriation  Accounts  : 
Bad  Debts  Collected 
Other  Additions  to  Surplus 
Expenses  Elsewhere  Unprovided  for 
Dividends  on  Outstanding  Stocks 
Amortization  Elsewhere  Unprovided  for 
Appropriations  to  Reserves 
Gifts  to  Controlled  Corporations 
Other  Appropriations 
Bad  Debts  Written  Off 
Other  Deductions  from  Surplus 

I  (Form  16 — Concluded) 


440 


TENTATIVE  CLASSIFICATION  OF  THE  OPERATION  ACCOUNTS  OF 
WATER  SUPPLY  ENTERPRISES. 

INCOME  ACCOUNTS. 

GROSS  INCOME  FROM  OPERATION. 

I.    Income  From  Water'^Service. 

A~Pay  Rates  for  Private  Consumers  Within  City 

1.  Metered  Domestic  Rates 

2.  Metered  Manufacturing  and  Commercial  Rates 

3.  Unmetered  Domestic  Rates 

4.  Unmetered  Manufacturing  and  ConamerciarRates 

B.  Pay  Rates  for  Private  Consumers  Outside  City 

5.  Metered  Domestic  Rates 

6.  Metered  Manufacturing  and  CommerciaPRates 

7.  Unmetered  Domestic  Rates 

8.  Unmetered  Manufacturing  and  Commercial  Rates 

C   Pay  Rates  for  Other  Waterworks 

9.  Rates  for  Other  City  and  Private  Water  Enterprises 

D.  Fees  for  Shutting  off  and  Turning  on  Water 

10.  Fees  for  Shutting  off  and  Tuming'on]Water 

E.  Pay  Rates  for  City 

11.  Fire  Department 

12.  Sewer  Flushing 

13.  Street  Sprinkling  and  Washing 

14.  Public  Schools 

15.  All  Other  PubUc  Buildings 

16.  Public  Parks,  Fountains,  and  Troughs 

17.  All  Other  Municipal  Purposes 

F.  Free  Rates  for  City 

18.  Fire  Department 

19.  Sewer  Flushing 

20.  Street  Sprinklmg  and  Washing 

21.  Public  Schools 

22.  All  Other  Pubhc  Buildings 

23.  Public  Parks,  Fountains  and  Troughs 

24.  All  Other  Municipal  Purposes 

(j.  Free  Rates  for  Private  Consumers 

25.  Water  for  Churches,  Private  Charities,  etc. 

H.  Value  of  Water  Used  by  Water-Supply]^ystem 

26.  For  Purification  Purposes 

27.  For  Pumping  Purposes 

28.  For  Plant  and  Other  Private  Fire  Protection 

29.  For  all  Other  Uses  and  Purposes 

II.  Income  Other  Than  From  Water  Service 

/.  Income  from  Accessory  Enterprises 

30.  Income  from  Plumbing  Work  for  Compensation 

31.  Rents  from  Rental  Property 

32.  Rents  from  Meters,  Meter  Boxes,  and  Vaults 

33.  Income  from  Stables,  Teams,  and  Teamsters 

34.  Income  from  Forest  Lands 

35.  Income  from  Other  Accessory  Enterprises 

J.  Earnings  of  Invested  Funds 

36.  Earnings  of  Sinking  Funds 

37.  Earnings  of  Depreciation  Funds 

38.  Earnings  of  Other  Reserve  Funds 

(Form  17) 
441 


(WATER  SUPPLY  ENTERPRISES) 
INCOME  ACCOUNTS— Continued 

K.    Irderest  on  Cash  Balances  in  Bank: 

39.  Interest  to  Credit  of  Enterprise 

40.  Interest  to  Credit  of  City 

L.    Income  from  Miscellaneous  Sources: 

41.  Sundry  Rents 

42.  Sundry  Services 

43.  Sundry  Objects 

44.  Permits 

45.  Gains  ^rom  Bond  Transactions 

46.  Other  Gains 

Income  Clearing  Accounts: 

Income  from  Water  Service 
Income  from  Accessory  Enterprises 
Earnings  from  Invested  Funds 
Income  from  Miscellaneous  Sources 

EXPENSE  ACCOUNTS 

TOTAL  EXPENSES  OF  OPERATIONS 

GROUP   1.     EXPENSES  OF  WATER  SERVICE 

III.     Expenses  of  General    Management 

M.  General  Administrative  Expenses 

Division  1. — Expenses  Payable  to  Public 

100.  Salaries  and  Expenses  of  General  Administrative  Officers  and 
Employees 

101.  Rent  of  Offices,  etc. 

102.  Other  General  Administrative  Office  Expenses 

103.  Stationery,  Printing,  and  Advertising 

104.  Law  Expenses 

105.  Sundry  General  Administrative  Expenses 
Division  2. — Expenses  Payable  to  City 

106.  Rent  of  City  Offices  for  Administrative  Purposes 

N,    Accounting  Expenses: 

Division  1. — Expenses  Payable  to  Public 

107.  Salaries  and  Expenses  of  Accounting  Officers  and  Employees 

108.  Rent  of  Offices,  etc 

109.  Other  Accounting  Office  Expenses 

110.  Stationeiy,  Printing  and  Advertising 

111.  Sundry  Accounting  Expenses 
Division  2. — Expenses  Payable  to  City 

112.  Proportion  of  Salaries  and  Expenses  of  Accounting  Officers  and 
Employees  of  City 

113.  Rent  of  City  Offices  for  Accounting  Purposes 

O.     Operating  Management  Expenses: 

Division  1. — Expenses  Payable  to  Public 

114.  Salaries  and  Expenses  of  Operating  Management  Officers 

115.  Laboratory  Salaries  and  Expenses 

116.  Salaries    and    Expenses    of    Other    Operating    Management 
Employees 

117.  Rent  of  Offices 

118.  Other  Office  Expenses  of  Operating  Management 

(Form  17 — Continued) 
442 


(WATER  SUPPLY  ENTERPRISES) 
EXPENSE  ACCOUNTS— Continued 

0.    Operating  Management  Expenses, — Continued 
Division  1. — Expenses  Payable  to  Public 

119.  Rents  and  Expenses  of  Shops,  Storerooms,  etc. 

120.  Stationery  and  Printing 

121.  Advertising  and  Soliciting 

122.  Law  Expenses 

Division  2. — Expenses  Payable  to  City 

123.  Proportion  of  Salaries  and  Expenses  of  Operating  Management 
Officers  and  Employees  of  City 

124.  Rent  of  City  Offices  for  Operating  Management 

125.  Rent  of  City  Buildings  for  Shops,  Storerooms,  etc. 

126.  Proportion  of  Law  Expenses  of  City 

IV.     Expenses  for  Collecting    and    Supplying    Water 

P.    Expenses  for  Care  of  Sources  of  Supply 
Division  1. — Surface  supply 

127.  Drainage  area  and  reservations 

128.  Impounding  Dams  and  Reservoirs 

129.  Lake  and  River  Cribs 
Division  2. — Ground  Supply 

130.  Springs  and  Wells 

131.  Infiltration  Galleries  and  Tunnels 

132.  Collecting  Conduits  and  Reservoirs 

Q.    Expenses  for  Care  of  Intakes  and  Aqueducts: 

133.  Gravity  Intakes  and  Suction  Maios 

134.  Aqueducts  and  Supply  Mains 

R.    Expenses  for  Purification  of  Water: 

135.  By  Sedimentation 

136.  By  Coagulation 

137.  By  Softening 

138.  By  Slow  Sand  Filtration 

139.  By  Mechanical  Filtration 

140.  By  Other  Methods 

S.     Expenses  for  Pumpipg  Water: 

141.  Salaries  and  Wages 

142.  Fuel  (Coal,  Wood,  Gas,  Oil,  etc.) 

143.  Oils  and  Waste 

144.  Supplies 

145.  Waterpower 

146.  Electric  Power 

147.  Other  Power 

148.  All  Other  Pumping  Expenses 

149.  Proportion  of  Steam  or  Other  Power  Plant  Expenses 

T.    Expenses  for  Transmission  and  Distribution  Storage  of  Water: 

150.  Force  Mains 

151.  Reservoirs  and  Fire  Cisterns 

152.  Tanks  and  Standpipes 

U.    Expenses  for  Distribution  of  Water: 

153.  Main  Pipes  and  Specials 

154.  Main  Valves  and  Valve  Boxes 

155.  Fire  Hydrants 

156.  Other  Main  Pipe  Appliances 

157.  Service  Pipes  and  Stops  Owned  by  Enterprises 

158.  Meters  and  Meter  Boxes  and  Vaults  Furnished  Rent  Free 

159.  Fountains  and  Troughs 

160.  All  Other 

(Form  17 — Continued) 

443 


(WATER  SUPPLY  ENTERPRISES) 
EXPENSE  ACXOUNTS— Continued 

V.    Expenses  for  Water  Service  Repairs 
MM.  General  Administrative  Repairs: 

161.  Repairs  of  General  Administrative  Buildings  and  Equipment 

NN.    Accounting  Repairs 

162.  Repairs  of  Accounting  Equipment 

163.  Repairs  of  Operating  Management  Buildings  and  Equipment 

00.     Operating  Management  Repairs: 

PP.     Repairs  at  Sources  of  Supply: 
Division  1. — Surface  Supply 

164.  Drainage  area  and  reservations 

165.  Impounding  Dams  and  Reservoirs 

166.  Lake  and  River  Cribs 
Division  2. — Ground  Supply 

167.  Springs  and  Wells 

168.  Infiltration  Galleries  and  Tunnels 

169.  Aqueducts  and  Supply  Mains 

QQ.     Repairs  of  Intakes  and  Aqueducts: 

170.  Gravity  Intakes  and  Suction  Mains 

171.  Aqueducts  and  Supply  Mains 

RR,     Repairs  of  Purification  System: 

172.  Buildings 

173.  Settling  Basins 

174.  Coagulating  Basins 

175.  Softening  Equipment 

176.  Slow  Sand  Filters 

177.  Mechanical  Filters 

178.  Other  Purification  Equipment 

SS,      Repairs  of  Pumping  System: 

179.  Buildings 

180.  Boilers 

181.  Steam  Piping  and  Equipment 

182.  Steam  and  Power  Pumping  Machinery 

183.  Waterpower  Equipment 

184.  Electric  Power  Equipment 

185.  Other  Power  Equipment 

186.  Other  Station  Equipment 

187.  Proportion  of  Repairs  of  Steam  and  Other  Power  Plant  and 
Equipment 

TT.     Repairs  of  Transmission  and  Distribution  Storage  System: 

188.  Force  Mains 

189.  Reservoirs  and  Fire  Cisterns 

190.  Tanks  and  Standpipes 

UU.    Repairs  of  Distribution  System: 

191.  Main  Pipes  and  Specials 

192.  Main  Valves  and  Valve  Boxes 

193.  Fire  Hydrants 

194.  Other  Main  Pipe  Appliances 

195.  Services  Pipes  and  Stops  Owned  by  Enterprise 

196.  Meters  and  Meter  Boxes  and  Vaults  Furnished  Rent  Free 

197.  Fountains  and  Troughs 

198.  All  Other 

(Form  17 — Continued) 

444 


(WATER  SUPPLY  ENTERPRISES) 

EXPENSE  ACCOUNTS- Continued 

VI.     Expenses  for  Water  Service  Insurance 

199.  On  General  Administration  Buildings  and  Equipment. 

200.  On  Accounting  Equipment. 

201.  On  Operating  Management  Buildings  and  Equipment 

202.  On  source  of  supply  buildings  and  equipment 

203.  On  Intake  and  Aqueduct  Buildings  and  Equipment 

204.  On  Purification  System  Buildings  and  Equipment 

205.  On  Pumping  System  Buildings  and  Equipment. 

206.  On  Transmission  and  Distribution  Storage  System  Buildings 
and  Equipment 

207.  On  Distribution  System  Buildings  and  Equipment. 

VII.     Expenses  for  Water  Service  Depreciation 

208.  On  General  Administration  Buildings  and  Equipment 

209.  On  Accounting  Equipment 

210.  On  operating  management  buildings  and  equipment. 

211.  On  Sources  of  Supply 

212.  On  Intakes  and  aqueducts 

213.  On  Purification  System. 

214.  On  Pumping  System 

215.  On  Transmission  and  Distribution  Storage  System 

216.  On  Distribution  System 

GROUP  2.     EXPENSES  OTHER  THAN  FOR  WATER  SERVICE 
VIII.     Miscellaneous  Expenses 

y.     Expenses  of  Accessory  Enterprises: 

217.  Plumbing  Work  for  Compensation 

(a)  General     (b)  Repairs     (c)  Insurance     (d)  Depreciation 

218.  Rental  Property 

(a)  General     (b)  Repairs     (c)  Insurance     (d)  Depreciation 

219.  Meters  and  Meter  Boxes  and  Vaults  Rented  to  Consumers 
(a)  General     (b)  Repairs     (c)  Insurance     (d)  Depreciation 

220.  Stables,  Teams  and  Teamsters. 

(a)  General     (b)  Repairs     (c)  Insurance     (d)  Depreciation 

221.  Forest  Lands 

(a)  General     (b)  Repairs     (c)  Insurance     (d)  Depreciation 

222.  Other  Accessory  Enterprises 

(a)  General     (b)  Repairs     (c)  Insurance     (d)  Depreciation 

TT.     Expenses  of  Invested  Funds: 

223.  Expenses  of  Sinking  Funds 

224.  Expenses  of  Depreciation  Funds 

225.  Expenses  of  Other  Reserve  Funds 

X,     Sundry  Expenses: 

226.  Sundry  Services  and  Objects 

227.  Gratuitous  Work 

228.  Losses  on  Bond  Transactions 

229.  Other  Losses 

IX.     First  Charges  for  Water  and  Taxes 

Y.     Cost  of  Water: 

230.  Annual  Payments  for  Water  Rights 

231.  Annual  Dues  to  Other  Water-Supply  Systems 

232.  Amortization  of  expiring  Term  Water  Rights 

(Form  17 — Continued) 
445 


(WATER  SUPPLY  ENTERPRISES) 
EXPENSE  ACCOUNTS— Continued 

Z.     Taxes  and  Franchise  Diies: 

Division  1.     Taxes  and  Dues  Actually  Paid  or  Payable  by  Enterprise 

233.  Real  and  Personal  Taxes 

234.  Taxes  on  Capital  Stock 

235.  Taxes  on  Earnings  or  Receipts 

236.  Other  Taxes 

237.  Franchise  dues 

238.  Amortization  of  Expiring  Term  Franchises 

Division  2.  Taxes  and  Dues  Chargeable  against  Municipally  Operated 
Enterprises  by  Operating  City,  other  than  those  actually  paid  or 
payable 

239.  Real  and  Personal  Taxes 

240.  Taxes  on  Beamings  or  Receipts 

241.  Other  Taxes 

242.  Franchise  Dues 

243.  Amortization  of  Expiring  Term  Franchises 

Expense  Clearing  Accounts: 
Franchise  Dues 
Fuel 

Injuries  to  Persons 
Law  Expenses 
Oil 

Stables,  Teams,  and  Teamsters 
SuppUes 
Taxes 
Waste 
Work  Equipment 

(Form  17 — Concluded) 


TENTATIVE  CLASSIFICATION  OF  THE  ALLOCATION  ACCOUNTS 
OF  WATER-SUPPLY  ENTERPRISES 

X.  Interest  Paid  and  Payable 

300.  Interest  on  Funded  and  Fixed  Debts 

301.  Interest  on  Real  Estate  Mortgages 

302.  Interest  on  Current  Liabilities 

XI.  Dividends  and  Assessments 

303.  Dividends  on  Preferred  Stock 

304.  Dividends  on  Common  Stock 

305.  Apportionment  to  individuals  and  Firm  Members. 

306.  Profit  and  Loss  Assessments 

307.  City  Profit  and  Loss  Allocation 

XII.     Sundry  Allocation 


308.  Sinking  Fund  Appropriation 

309.  Depreciation  Fund  Allocation 

310.  Other  Reserve  Fund  Allocation 

311.  Capital  Account  Transfers 

Supplemental  Allocation  Account: 
Current  Transactions  with  City 

(Form   IS) 
446 


TENTATIVE    CLASSIFICATION    OF    THE    PROPERTY    ACCOUNTS 

OR   ACCOUNTS   WITH   COST   AND   PRESENT   VALUE   OF 

WATER-SUPPLY  ENTERPRISES 

DIVISION  1.     COST  AND  VALUE  OF  OPERATING  W^ORKS 

AND    PROPERTY 

XX.    Value  as  a  Going  Concern 

A .  Preliminary  Expenditures: 

400.  Engineering  Expenses 

401.  Law  Expenses 

402.  Injuries  to  Persons  and  Property 

403.  Insurance 

404.  Interest  and  Commissions 

405.  Taxes 

406.  Other  Expenditures 

407.  Cost  of  Charter 

B.  Franchise 

408.  Operating  Franchises  and  Easements 

XXI.    Value  of  Land,  Buildings,  and  Equipments 

C.  Land  and  Equipment  for  Administrative  Offices: 

409.  Land  and  Equipment  for  Administrative  Ofl&ces. 

D.  Equipment  for  Accounting  Offices: 

410.  Equipment  for  Accounting  Offices 

E.  Land,  Buildings,  and  Equipment  for  Operating  Management: 

411.  Operating  Management  Offices 

(a)  Land     (b)  Buildings     (c)  Fixtures  and  Equipment 

412.  Laboratory 

(a)  Land     (b)  Buildings     (c)  Fixtures  and  Equipment 

413.  Shops  of  Operating  Management 

(a)  Land     (b)  Buildings     (c)  Fixtures  and  Equipment 

414.  Other  General  Equipment 

(a)  Land     (b)  Buildings     (c)  Fixtures  and  Equipment 

XXII.    Value  of  Land,  Buildings,  and  Equipment  for  Water  Service 

F.  Land,  Buildings,  and  Equipment  at  Sources  of  Supply: 

415.  Reservations 

(a)  Land     (b)  Buildings     (c)  Equipment 

416.  Impounding  Dams  and  Reservoirs 

(a)  Land     (b)  Dams     (c)  Reser\^oirs     (d)  Buildings 
(e)  Equipment 

417.  Lake  and  River  Cribs 

(a)  Land     (b)  Cribs     (c)  Buildings     (d)  Equipment 

418.  Springs  and  Wells 

(a)  Land     (b)  Springs     (c)  Wells     (d)  Buildings     (e)  Equipment 

419.  Infiltration  Galleries  and  Tunnels 

(a)  Land  and  Right  of  Way     (b)  Galleries     (c)  Tunnels 
(d)  Buildings     (e)  Equipment 

420.  Collecting  Conduits  and  Reservoirs 

(a)  Land  and  Right  of  Way     (b)  Conduits     (c)  Reservoirs 
(d)  Buildings     (e)  Equipment 

G.  Land,  Buildings,  and  Equipment  for  Intakes  and  Aqueducts: 

421 .  Gravity  Intakes  and  Suction  Mains 

(a)   Land  and  Right  of  Way     (b)  Gravity  Intakes     (c)  Suction 
mains     (d)  Suction  Wells     (e)  Buildings     (f)  Equipment 

(Form  19) 
447 

^       OF   THE 

I  i».ii\#coeiTV 


(WATER  SUPPLY  ENTERPRISES) 


G.    Land,  Buildings,  and  Equipment  for  Intakes  and  Aqueducts, — Continued 
422.     Aqueducts  and  Supply  Mains 

(a)  Land   and   right   of  way     (b)  Aqueducts     (c)  Supply  Mains 


(d)  Wet  Wells     (e)  Buildings     (f)  Equipment 
H.    Land,  Buildings  and  Equipment  for  Purification  Works: 

423.  Settling  Basins 

^g  (a)  Land     (b)  Basins     (c)  Buildings     (d)  Equipment 

424.  Coagulating  Basins 

(a)  Land     (b)  Basins     (c)  Buildings     (d)  Equipment 

425.  Softening  Plant 

(a)  Land     (b)  Buildings     (c)  General  Plant     (d)   Minor  Equip- 
ment 

426.  Slow  Sand  Filters 

(a)  Land     (b)  Filters     (c)  Buildings     (d)  Equipment 

427.  Mechanical  Filters 

(a)  Land     (b)  Buildings     (c)  Filters     (d)  Equipment 

428.  Other  Purification  Equipment 

(a)  Land     (b)  Buildings     (c)  General  Plant     (d)  Minor  Equip- 
ment 
/.     Land,  Buildings,  and  Equipment  for  Pumping: 

429.  Pumping  Stations 

(a)  Land     (b)  Buildings 

430.  Pumping  Plant 

(a)  Steam  and  Power  Pumps     (b)  Other  Pumping  Equipment 

431.  Steam  Plant 

(a)  Boilers  with  Settings,  Stacks,  etc. 

(b)  Engines     (c)  Steam  Pip>ing,  Condensers,  etc. 

(d)  Other  Steam  Plant  Equipment 

432.  Waterpower  Plant 

(a)  Land     (b)  Dams     (c)  Canals     (d)  Buildings 

(e)  Other  Structures     (f )  Water  Wheels  and  Connections 
(g)  Other  Equipment 

433.  Electric  Power  Equipment 

(a)  Motors  and  Dynamos 

(b)  Switchboards  and  Apparatus     (c)  Minor  Equipment 

434.  Gas  and  Other  Power  Equipment 

(a)  Producers  and  Engines     (b)  Gas  and  Oil  Engine  Equipment 

(c)  Other  Equipment 

435.  Other  Station  Equipment 

(a)  Oil  and  waste  Apparatus     (b)  Station  Repair  Shop  Equip- 
ment    (c)  Other  Equipment 

436.  Proportion  of  Value  of  Steam  and  Other  Power  Plant  and 

Equipment 
J.    Land,   Buildings,   and   Equipment   for   Transmission  and   Distribution 
Storage  System 

437.  Force  Mains 

(a)  Land  and  Right  of  Way     (b)  Mains  and  Specials 

(c)  Valves  and  Valve  Boxes     (d)  Other  AppUances 
(e)  Buildings  and  Other  Structures 

438.  Reservoirs  and  Fire  Cisterns 

(a)  Land     (b)  Reservoirs     (c)  Cisterns 

(d)  Buildings     (e)  Equipment 

439.  Tanks  and  Standpipes 

(a)  Land     (b)  Tanks     (c)  Standpipes     (d)  Buildings 

(e)  Equipment 

K.^  Land,  Buildings,  and  Equipment  for  Distribution  System 

440.  Land  and  Right  of  Way 

441.  Main  Pipes  and  Specials 

442.  Main  Valves  and  Valve  Boxes 
(a)  Valves     (b)  Boxes 

443.  Fire  Hydrants 

(Form  19 — Continued) 

448 


(WATER  SUPPLY  ENTERPRISES) 

K,    Land,  Buildings,  and  Equipment  for  Distribution  System. — Continued 

444.  Other  Main  Pipe  Appliances 

(a)  Regulators,  Air  Chambers,  Relief  Valves,  etc. 

(b)  Blow-off  Cocks,  etc. 

445.  Service  Pipes  and  Stops  Owned  by  Enterprise 

446.  Meters  and  meter  Boxes  and  Vaults  Furnished  Rent  Free 
(a)  Meters  and  Connections     (b)  Meter  Boxes  and  Vaults 

447.  Fountains  and  Troughs 

448.  All  Other 

XXIII.    Value  of  General  Tools  and  Accessories  Other  than  for 
General  Shop  Use,  etc. 

L.    Tools  and  Accessories: 

449.  AU  General  Tools 

450.  All  General  Apparatus  and  Equipment 

451.  All  general  Accessories 

XXIV.     Value  of  Water  Rights 

M.  [Water  Rights: 

452.  Water  Rights  Owned  in  Perpetuity 

453.  Terminable  Water  Rights 

DIVISION  II.— VALUE  OF  ACCESSORY  PROPERTY 
XXV.    Value  of  Accessory  Property 

N.    Land,  Buildings  and  Equipment  for  Miscellaneous  Purposes 

454.  Of&ces,  Shops,  Storerooms,  etc. 
(a)  Land     (b)  Buildings 

455.  Rental  Property 

(a)  Land     (b)  Buildings 

456.  Meters  and  Meter  Boxes  and  Vaults,  Rented  to  Consumers 
(a)  Meters  and  Connections     (b)  Meter  Boxes  and  vaults 

457.  Stables  and  teams 

(a)  Land     (b)  Buildings     (c)  Equipment  for  Stables 
(d)  Live  Stock     (e)  Wagons     (f)  Harness  and  Team  Equipment 
Grand  Total  Value  of  All  Physical  and  Intangible  Property  of  Enterprise 

(Form  19 — Concluded) 


449 


(WATER  SUPPLY  ENTERPRISES) 
CONDENSED  ANALYTICAL  COST   ACCOUNTING  SUMMARY 


AMOUNTS 

TRANSACTIONS 

Total 

per  capita 
supplied 

Per 
1,000,000 

gallons 
supplied 

to  pipes 

Per  mile  of 
equivalent 
4-inch  dis- 
tribution 
pipej     ^ 

1.  Income    from    Domestic 
rates 

$ 

$ 

$ 

$ 

2.  Income    from    Mfg.  and 

Commercial  Rates 

3.  Income  from  Water  Ser- 

vice for  City    . . . 

4.  Value    of   Water    Con- 

sumed by    Enterprise 

5.  Other     Income     from 

Water  Service 

6.  Gross      Income      from 

Water  Service 

7.  Income  other  than  from 

Water  Service 

8.  Gross   Income  from  Op. 

9.  Expenses    of   General 

Management 

10.  Expenses  for  Collecting 

and  Supplying  Water 

11.  Expenses  for  Repairs. . . 

12.  Expenses  for  Insurance 

13.  Exp.  for  Depreciation. 

14.  Miscellaneous  Expenses 

15.  First  Charges 







16.  Total     Operating     Ex- 

penses  

17.  All    General    Expenses 

18.  All  Expenses  at  Sources 

of  Supply 





19.  All  Expenses  of  Intakes 

and  Aqueducts 

20.  AU   Expenses  of  Purifi- 

cation system 

21.  All  Expenses  of  Pump- 

ing System 

22.  All  Expenses  of  Trans- 

mission and  Distribu- 
tion Storage  System.. 

23.  All  Expenses  of  Distribu- 

tion System 

24.  Total  Exp.ofWtr.Service 

25.  Six  %  of  Value  of  Assets 

26.  Net  Anticipated  Income 

from  Operation 

27.  Net  Income  from  Oper- 

ation Realized 

28.  Interest  Expenses 

29.  Anticipated  Profit  or  loss 

30.  Profit  or  Loss  Realized 





(Form  20) 
460 


PROPOSED  CENStJS   SCHEDULE   FOR  SECURING   UNIFORM    RE- 
PORTS OF  THE  TRANSACTIONS  AND  CONDITIONiOF 
WATER-SUPPLY   ENTERPRISES 
Part  I.    Financial  Transactions  for  Year  Ending 

Income 

I.  Income  from  Water  Service: 

A.  (1  and  3)  Domestic  Pay  Rates  Within 

City $ 

A.  (2  and  4)  Manufacturing  and  Commer- 
cial Pay  Rates  Within  City 

B.  (5  and  7)  Domestic  Pay  Rates  Outside 

of  City 

B.  (6  and  8)  Manufacturing  and  Commer- 
cial Pay  Rates  Outside  of  City 

C.  Pay  Rates  for  Other  Water  Companies         

D.  Fees  for  Shutting  off  and  Turning  on 
■^a^^gj. 

E.  Pay  Rates  for  City. ...'.'. .'....' 

F.  Free  Rates  for  City 

G.  Free  Rates  for  Private  Consumers. ...  

H.  Water  Used  by  Water-Supply  System  


//.  Income  Other  Than  From  Water  Service : 

I.   Income  from  Accessory  Enterprises. ...       $. 

J.  Earnings  of  Invested  Funds 

K.  Interest  on  Cash  Balances  in  Bank 

L.  Income  from  Miscellaneous  Sources 


$ 


Gross  Income  from  Operation $ . 

Expenses 
Group  1.    Expenses  op  Water  Services 

///.  Expenses  for  General  ManoLgement  % 

IV    Expenses  for  Collecting  and  Supplying  Water: 

P.  Expenses  for  Care  of  Source  of  Supply  

Q.  Expenses  for  Care  of  Intakes  and  Aque- 
ducts   

R.  Expenses  for  Purification  of  Water 

S.  Expenses  for  Pumping  Water 

T.  Expenses  for  Transmission   and  Distri- 
bution Storage  of  Water 

U,  Expenses  for  Distribution  of  Water. ...  

$. 

V.  Expenses  for  Water  Service  Repairs: 

MM.  Repairs  of  General  Management  Build- 
ings and  Equipment $ 

PP.    Repairs  at  Sources  of  Supply 

QQ.   Repairs  of  Intakes  and  Aqueducts ...  

RR.  Repairs  to  Purification  System 

SS.     Repairs  of  Pumping  System , . 

TT.  Repairs  of  Transmission  and  Distri- 
bution Storage  System 


(Form  21) 
451 


(WATER  SUPPLY  ENTERPRISES) 

EXPENSES  OF  WATER  SERVICES— Continued 

VI.  Expenses  for  General  and  Water  Service  Insurance $ , 

VII.  Expenses  for  General  and  Water  Service  Depreciation 


Total  Expenses  for  Water  Service $. 

Group  2.    Expenses  Other  Than  for  Water  Service 

VIII.  Miscellaneous  Expenses: 

V.  Expenses  of  Accessory  Enterprises $ 

W.  Expenses  of  Invested  Funds 

X.    Sundry  Expenses 


IX.  First  Charges  for  Water  and  Taxes: 

Y.  Cost  of  Water 

Z.  Division  1. — Taxes  and  Franchise  Dues 

Other  Than  Those  Paid  to  Operating  City 
Z.  Division  2. — ^Taxes  Paid  by  Municipally 

Operated  Enterprise  to  City 


Total  Expenses]of  Operation 

Profit  and  Loss  Account 

Gross  Income  from  Operation $ . 

Total  Expenses  of  Operation 


Gross  Profit  or  Net  Income  from  Operation* 
Interest 

Net  Profit  or  Net  Income  Surplusf 

Dividends  and  Assessments 

Net  Investment  Transfers 

Current  Appropriation  Surplus^ 


♦The  excess  of  expense  is  here  called  "total  loss  from  operation." 
fThe  excess  of  interest  and  other  expenses  is  here  called  "net  loss." 
JThe  excess  of  all  expenses,  charges,  and  payments  is  here  called  "deficit." 

(FoBM  21— Concluded) 


452 


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458 


PROPOSED     CENSUS^  SCHEDULE     FOR     SECURING     UNIFORM 
REPORTS  OF  THE  TRANSACTIONS  OF  WATER-SUPPLY 
ENTERPRISES.— Continued 


Part  III. — Condensed  Balance  Sheet 

Total  Assets  : 

Miscellaneous  Cash $ . 

Income  Arrears  (Recoverable) 

Accrued  and  Unassessed  Income  of  Current  Year 

Sundry  Debtors 

Materials  and  Supplies 

Investments 

Sinking  and  Other  Reserve  Funds 

Present  Value  of  Physical  Property 

Operating  Works  or  Property 

Accessory  Property 

Deficit  (In  the  case  of  Municipally  Owned  Water-Supply  Sys- 
tem this  is  a  liabihty  of  the  city  to  the  enterprise) .... 

Liabilities  and  Proprietary  Interests: 
Debt  Liabilities: 

Deposits  by  Customers $. 

Income  for  future  Period  Levied  in  Advance 

Audited  Bills  and  Warrants  Outstanding 

Notes  Payable,  Revenue  Loans,  etc 

Interest  and  dividends 

Sundry  creditors 

Bonds,  Debentures,  etc 


Proprietary  Interests: 

City $. 

Corporation 

Capital  Stock 

Surplus 

(Form  23) 
454 


(NATIONAL  BANK  REPORT) 


Enter  charter  No. 
of  Bank  here. 


No. 


(use  the  blank  lines  if  necessary,  but  do  not 
erase  or  change  ant  op  the  printed  items.) 


Report  of  the  Condition  of  "The " 

At ,  IN  the  State  of ,  at  the  Close  of  Business 

on  the Day  of ,  190 


De. 


RESOURCES 


Loans  and  Discounts  (see  schedule) 

Overdrafts,  secured,  $ ;  unsecured,  $ 

(see  schedule 

U.  S.  Bonds  to  secure  Circulation  (par  value)  ... 

per  cents, per  cents 

U.  S.  Bonds  to  secure  U.S.  Deposits  (par  value). 


per  cents 

Other  Bonds  to  secure  U.  S.  Deposits 

U.S.  Bonds  on  hand  (par  value) per  cents 

Premium  on  Bonds  for  Circulation,  $ ;  Premiiun 

on  other  U.S.  Bonds,  $ 


Bonds,  Securities,  etc.,  including  premium  on  same  (a 

schedule) 

Banking  House,  $ ;  Furniture  and  Fixtures  $ 

Other  Real  Estate  owned  (see  schedule) 


Due    from    National    Banks    (not    approved    reserve 
agents) 

Due  from  State  and  Private  Banks  and  Bankers, 
Trust  Companies,  and  Savings  Banks 

Due  from  approved  Reserve  Agents  (see  schedule) 


14.  Checks  and  other  Cash  Items  (see  schedule) 

15.  Exchanges  for  Clearing  House 

16.  Notes  of  other  National  Banks , 

17.  Fractional  Paper  Currency,  Nickels,  and  Cents. 


^1 


Clearing-H'se.C'tfic't's  (Sec.  5192) 

Gold  Coin 

Gold  Certificates.. 

Gold  Certificates  payable  to  order 

Silver  Dollars 

Silver  Certificates 

Fractional  Silver  Coin 


Total  Coin  and  Certificates.. 
(.  Legal-Tender   Notes 


19.  Redemption  Fund  with  U.  S.  Treasurer  (not  more  than 

5  per  cent  on  Circulation) 

20.  Due  from  U.  S.  Treasurer 


DOLLARS 


CTS, 


Total  (to  avoid  discrepancies  the  total  should  be  footed) 


Place  for  official 
seal  to  he  affixed  by 
officer  before  whom 
acknowledged.  See 
Act  Feb.  26.  1881. 
Notary  must  not  be 
an  officer  or  director 
of  the  bank. 


State  of County  of. 

SvDorn  to  and  subscribed  before  me  this 


day     of 190     ;     and     I 

hereby  certify  that  I  am  not  an  officer  or  a  director  of  this  bank. 


Notary  Public. 


(Form  24) 
455 


(NATIONAL  BANK  REPORT— Continued) 


Report  of  the  Condition  of  "The : " 


At ,  IN  the  State  of ,  at  the  Close  of  Bvsimsss 


ON  THE Day  of. 


190 


Cr. 


LIABILITIES 

DOLLARS 

CTS. 

1       Canital  Stock  Daid  in                                       

3.     Undivided    Profits    (including   amounts,    if 
any,    set   aside    for    special    purposes, 

except  Item  22) $.. 

Less     Current     Expenses,    Interest,     and 
Taxes  paid 

4.     Circulating  Notes  secured  by  U.S.  Bonds.. ..$.. 
Less  amount  on  hand  and  in  Treasury  for 

redemption  or  in  transit 

5      State  Bank  Circulation  outstanding 

.... 

6      Due  to  National  Banks  (not  approved  Reserve  AorentR') 

7.'     Due  to  State  and  Private  Banks  and  Bankers. 

8.  Due  to  Trust  Companies  and  Savings  Banks... 

9.  Due  to  approved  Reserve  Agents  (see  schedu] 

° 

e) 

10.     Dividends  unpaid 

11      Individual  Deposits  subject  to  Check  $  .... 

— 

— 

— 

— 

12      Savings  Deposits                           

13*     Demand  Certificates  of  Deposit 

14.     Time  Certificate  of  Deposit 

15      Certified  Checks         

16.     Cashier's  Checks  outstanding 

17.     United  States  Deposits 

18.     Deposits  of  U.  S.  Disbursing  Officers 

19.     Bonds  Borrowed , 

20      Notes  and  Bills  rediscounted    . 

21 .     Bills  payable,  including  Certificates  of  Deposit  represent- 

22.     Reserved  for  Taxes 

23.     Liabilities  other  than  those  above  stated 

....    ... 







i 

/,  ,  of  the  above-named  bank,  do  solemnly  swear  that  the  above  state 

(Cashier  or  President) 
ment  is  true,  and  that  the  SCHEDULES  on  back  of  the  report  fully  and  correctly  represent 
the  true  state  of  the  several  matters  therein  contained,  to  the  best  of  my  knowledge  and  belief. 


Correct. — A  ttest: 


NOTE. — This  report  must  be  sworn  to 
by  the  President  or  Cashier,  NOT  by 
any  other  officer;  attested  by  not  less 
than  three  Directors,  and  forwarded  to 
the  Comptroller  of  the  Currency  with  the 
least  possible  delay,  as  it  is  desired  to 
complete  the  summary  of  reports  as  soon 
as  possible  after  a  call  has  been  issued. 


To  be  attested 
by  three  Direc- 
t'yrs  other  than 
the  officer  verv- 
fying  the  report. 


Cashier. 


Directors. 


(Form  24 — Continued) 
456 


(NATIONAL  BANK  REPORT— Continued) 
CERTIFICATES  OF  DEPOSIT  REPRESENTING  MONEY  BORROWED. 


To  whom  issued 

Address 

Amotmt  on  demand 

Amount   on   time 

Rate  of 
interest 

1 

Total    (include    in 
Liabilities) 

Item    21, 

LOANS  Exceeding  the  Limit  Prescribed  by  Section  5200  of  the  Revised  Statutes,  including 

Amoimts  which  Exceed  this  Limit  due  from  State,  Private  Banks  and  Bankers,  Trust 

Companies,  and  Savings  Banks.     Overdrafts,  if  any,  to  be  classed  with  Loans. 


Name  of  borrower 

Enter   full 

amount  of 

loan 

1 

Name  of  borrower 

Enter  fuU 

amount  of 

loan 

From- 


BALANCES  DUE  FROM  OR  TO  APPROVED  RESERVE  AGENTS     To- 


Enter  name  and  location  of 
bank 

Amount 

Enter  name  and  location  of 
bank 

Amount 

Total  (Item  13,  Resources) 



ToTALdtem  9.  Liabilities) 

LIABILITIES  OF  OFFICERS  AND  DIRECTORS 


Names  of 

officers  and 

directors 

Official 
title 

Liability 

(individual 

or  firm)  as 

payers 

Liability 
(individual 
or  firm)  as 
indorsers 

or 
guarantors 

Checks  and 
cash  items   ' 

1                         ^ 

Overdrafts 

No.  of 

shares 
stock 
owned 

President 
Cashier  .... 
Vice-Pres.. 
Asst.  Cash. 
Directors... 
...do 



•••"••• 

••••• 

"Z" 

1 





do 

...do 

.  do  

Total 

1 

(Form  24— Continued) 
457 


(NATIONAL  BANK  REPORT— Continued) 


LOANS  AND  DISCOUNTS. 


(Including  Loans  and  Discounts  on  which  Officers  and 
Directors  are  Liable.) 


A.  On  demand,  paper  with  one  or  more  individual  or  tirm  names.... $ 

B.  On  demand,  secured  by  stocks,  bonds, and  other  personal  securities 

C  On  time    paper  with  two  or  more  individual  or  firm  names     . 

D.  On  time.single  name  paper(l  person  or  firm)  without  other  security 

E.  On  time,  secured  by  stocks,  bonds,  and  other  personal  securities. 

F.  Secured  by  real  estate  mtgs.  or  other  liens  on  realty  (see  schedule) 

Total  (Item  1,  Resources) 

Enter    the    amount             Included  in  the  above  ake — 
in  each  of  these  items,     G.  Bad  debts,  as  defined  in  Section  5204, 

"none"  if  there  is  no     H.  Other    suspended    or    overdue 
amount  to  enter.                       paper 

X.  Loans  for  accovmt  of  correspondents  made  from  their  fimds $  |     |     | 


Secured: 


OVERDRAFTS 


Unsecured: 


Stand'g  6  mos.  or  over 

Temporary 

Officers  and  Directors 
Total    (Item    2, 
Resources) 


Stand'g  6  mos.  or  over 

Temporary 

Officers  and  Directors 
Total     (Item    2, 
Resources) 


BONDS,  SECURITIES,  KlU.     (Bonds,  Clahns,  Judgments,  and  simUar  items  should  be 
included  under  this  head.) 

Enter  face 

value    of 

bonds 

Name  of  corporation 
issuing  bonds,  etc. 

Amoimt    at 
which  carried 
on  books 

Estimated 
actual  market 
value 

State  whether  taken 
for    "debts    pre- 
viously contracted 





ToTAX,     (Item     8, 
Resources) 



OTHER  REAL  ESTATE  OWNED 

Describe  property, 
state  form  of  con- 
veyance, and  from 
whom    obtained 


Amount  at 

which  carried 

on  books 


Amount  of 

prior  lien  on 

property,  if 

any 


Estimated 
actual  value 
of  property 


Date  when 
title  was 
acquired 


St'tewh'ther 
taken  for 
'debts    pre- 
viously con- 
tracted." 


Total  (Item  10, 
Resources) 


LOANS  AND  DISCOUNTS  Secured  by  Real  Estate  Mortgages  or 

other  Liens  on  Realty 

Give    name    of 
borrower,  form  of 

collateral,    and 
describe  property 

Amount  at 

which  carried 

on  books 

Amount  of 

prior  lien  ou 

property,  if 

any 

Estimated 
actual  value 
of  property 

Date  when 

security  was 

taken 

St'tewh'ther 
taken   for 
"debts  pre- 
viously con- 
tracted." 

* 

""' "  ■ 

Total  (Item  "F. 
Loans  and  Disc  , 



;                        j 

1 i 

CHECKS    AND    CASH    ITEMS    OTHER 
THAN     EXCHANGES     FOR     C.  H. 

AVERAGE   RESERVE  AND   INTEREST 

Average    reser\'-e    for    last 

Checks  and  drafts  on  banks,  etc., 
in  this  city,  not  members  of  clear- 

thirty  days  on  deposits 
bank  balances  in  bank 
With   Reserve  Aorents 

and 

was per  cent. 

Checks  and  drafts  on  othe 
not  members  of  clearing  h 

r banks 
ouse 

Aggregate  w 
The  highest 

IS per  cent. 

rate  of  inte- 
V  the  bank  on 

deposits  is percent. 

Total  (Item  14,  Resources) 

— 

At 

count 
id  on 

edis. 
bills  r 

laya 

bieis 

per  cent. 

percent. 

(Form  24 — Concluded) 
458 


BUILDING  AND  LOAN  ASSOCIATION 

BALANCE  SHEET 19... 

ASSETS: 
Loans: 

Real  Estate  Loans  with  Stock  Collateral %. 

Real  Estate  Loans  without  Stock  Collateral 

Stock  Loans 


Real  Estate 

Other  Investments  (if  any;  state  nature). 

Dues,  Fines,  etc.,  Delinquent 

Prepaid  Insurance  and  Taxes 

Accrued  Income 

Cash... 


LIABILITIES: 

Loans  Payable  (if  any) $. 

Unearned  Premiums 

Dues,  etc.,  Paid  in  Advance 

Accrued  Taxes  (if  any) 

Share  Capital:. 

Dues  Paid  in  and  Accrued  Profits  Thereon,  Per  Schedule  of 
Series  and  Values,  Annexed 


(Form  25) 


459 


(BUILDING  AND  LOAN  ASSOCIATION) 


PROFIT  AND  LOSS  ACCOUNT 
Year  Ended 19... 


Interest. . . 
Premiums. 


Fines. 


EARNINGS: 


Admission  and  Transfer  Fees. 

Rents  of  Real  Estate 

Less,  Insurance,  Taxes,  etc . . . 
Profit  on  Stock  Withdrawals. 


Interest  on  Stock  Withdrawn. 
Interest  on  Borrowed  Money. 
Administration  Expenses. . . . 


EXPENSES: 


Net  Profit  for  Apportionment  Among  Stock  Series 

(Form  26) 


460 


(BUILDING  AND  LOAN  ASSOCIATION) 


RECEIPTS  AND  DISBURSEMENTS 

Year  Ended 19 

Balance  (Beginning  of  Year) $. 

Receipts: 

Dues $ 

Interest,  Premiums  and  Fines 

Admission  and  Other  Fees 

Rents 

Loans  Repaid 

Sales  of  Real  Estate 

Money  Borrowed 


$. 


Disbursements  : 

Loans $ . 

Matured  Stock 

Stock  Withdrawals 

Salaries 

Rent,  Printing,  Stationeiy  and  Sundry  Expenses     . 

Real  Estate  Expenses 

Borrowed  Money 

Interest 


Balance  (End  of  Year) $. 

(Form  27) 


461 


(BUILDING  AND  LOAN  ASSOCIATION) 


STATEMENT  OF  SHARE  CAPITAL 
19 


Shares  Value  Per  Share  With- 

Value   drawal 


Series   Date  of  Borrow-  of      Value 

No.       Issue     ed  on     Free      Total     Dues  Prof-    Total     Series      per 

its  Share 


*Thie  amount  shoiild  agree  with  the  item  of  "Share  Capital"  shown  in  the  balance 
sheet. 

(Form  28) 


462 


THE  IDEAL  LIFE   INSURANCE  COMPANY 
BALANCE  SHEET,   DECEMBER  31,19.. 
ASSETS 
Real  Estate — (Appraised  Value): 
Office  Buildings: 

Home  Office $ 

Domestic  Branches ........ 

Foreign  Branches 


Other  Real  Estate 

Secured  Loans: 

On  Mortgage 

On  Policies 

On  Other  Collateral 

Bonds,  Stocks  and  Other  Market- 
able Securities — (Market  Value)' 
Bonds: 

Govemm't,  State  and  Municipal  of 

the  United  States  and  Canada        $ 

Railroad  and  Traction  Companies  in 

the  United  States  and  Canada 

Foreign — Held  Chiefly  to  Comply 

With  Statutory  Requirements. 

Miscellaneous 

Stocks:  ~ 

Railroad  and  Traction  Companies  in 

the  United  States  and  Canada         $. 
Financial  and  Insurance  Companies 
in  the  United  States  and  Canada 
Miscellaneous 

Syndicate  Subscriptions 

Cash:     . 

In  Banks  and  Trust  Companies : 

Home  Office  Subject  to  Check $ , 

Branches  and  Agencies,  Subject  to 

Check 

On  Deposit  on  Special  Terms., 

Deposits  with  Foreign  Governments. 

In  Transit 

On  Hand — At  Home  Office,  Branches 
and  Agencies 

Premiums  in  Course  of  Collection 
OR  Collected  and  not  Reported  : 

Fiist  Year  P  emiums 

Renewal  Premiums 

Annuities 

Agents'  Balances  and  Miscellaneous 

Advances 

Interest     and     Rentals     Due     or 
Accrued: 
Interest : 

On  Bonds  and  Dividends  on  Stocks.         $ . 

On  Secured  lioans 

On  Agents'  Advances  and  Balances. 
Miscellaneous 


Rentals. 


(FoKM  29) 
463 


THE  IDEAL  INSURANCE  COMPANY 
BALANCE  SHEET,  DECEMBER  31,  19. . 
LIABILITIES: 


General  Insurance  Reserve: 

(Describing  Basis) 

Current  Liabilities  : 

Under  Policies  and  Policy  Contracts : 
Death  Claims — Due  and  Unpaid. .  . 

Matured  Endownments 

Annuities — Due  and  Unpaid 

Dividends — Due  and  Unpaid 


Commissions  and  Current  Expenses: 
Commissions  on  Premiums  in  Course 

of  Collections 

Current  Expenses 


Premiums,  Interest  and  Rents  Pre- 
paid, and  Sundry  Deposits. . . . 

Capital  Stock: 

Surplus  and  Reserves: 

Contingency  Fund 

Investment  Fluctuation  Reserve  Fund 

Deferred  Dividend  Funds 

Annual  Dividend  Funds 

Unappropriated  Surplus 


(Form  29 — Concluded) 
464 


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Dec.  31.     Appropriations: 

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Balance — Being    Surplus    at 
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FORM  PRESCRIBED  BY  THE  ENGLISH  COMPANIES  ACT 


BALANCE  SHEET  OF  THE CO.,  MADE  UP  TO     19 


PROPERTY  AND  ASSETS: 

Property  held  by  Company: 
Showing: 
Immovable  Property,  distinguishing: 

(a)  Freehold  Land $ 

(b)  Freehold  Buildings 

(c)  Leasehold  Buildings 

Movable  Property,  distinguishing: 

(d)  Stock-in-Trade 

(e)  Plant 

The  cost  to  be  stated  with  deductions  for 

deterioration  in  value  as  charged  to  the 
Reserve  Fund  or  Profit  and  Loss 

Debts  Owing  to  the  Company: 
Showing: 

Debts  considered  good  for  which  the  Company 

holds  Bills  or  other  Securities 

Debts  considered  good  for  which  the  Company 

holds  no  Security 

Debts  considered  doubtful  and  bad 

Any  Debt  Due  from  a  Director  or  Other  OflBicer 
of  the  Company  to  be  separately  stated. 

Cash  and  Investments: 
Showing: 

The  nature  of  Investment  and  Rate  of  In- 
terest  

The  Amount  of  Cash,  where  Lodged,  and  if 
Bearing  Interest 


(Form  34) 
484 


FORM  PRESCRIBED  BY  TEE  ENGLISH  COMPANIES  ACT 
BALANCE  SHEET  OF  THE CO.,  MADE  UP  TO  19 

CAPITAL  AND  LIABILITIES: 
Capital: 


The  Number  of  Shares $ 

The  Amount  Paid  per  Share 

If  any  Arrears  of  Calls,  the  nature  of  the 

Arrears,  and  the  Names  of  the  Defaulters 

The  Particulars  of  any  Forfeited  Shares 

Debts  and  Liabilities  op  the  Company: 
Showing: 

The  Amount  of  Loans  on  Mortgages  or  Deben- 
ture Bonds 

The  Amount  of  Debts  Owing  by  the  Company 
distinguishing: 

(a)  Debts  for  which  Acceptances  have  been 
given 

(b)  Debts  to  Tradesmen  for  Supplies  of 
Stock-in-Trade  or  Other  Articles 

(c)  Debts  for  Law  Expenses 

(d)  Debts  for  Interest  on  Debentures  or 
Other  Loans 

(e)  Unclaimed  Dividends 

(f)  Debts  not  enumerated  above 

Reserve  Fund: 
Showing: 
The  Amount  set  aside  from  Profits  to  meet 
Contingencies 

Profit  and  Loss: 
Showing: 

The    Disposable    Balance    for   Payment    of 


Dividends,  etc. 


Contingent  Liabilities: 

Claims  Against  the  Company  not  Acknowl- 
edged as  Debts 

Moneys  for  which  the  Company  is  Contin- 
gently Liable 

(Form  34— Conclutjed) 
485 


FORM  SUGGESTED  BY  G.  S.  PITT  TO  SOCIETY  OF  INCORPORATED 
ACCOUNTANTS  AND  AUDITORS* 

BALANCE  SHEET (date) 

PROPERTIES  AND  ASSETS: 
Cash  and  Bills: 

Bank $ 

Bills  Receivable I 


Investments  : 
At  Middle  Market  Price,  viz.: 

British  Government $ . 

Colonies 


Sundry  Debtors: 

Secured 

Unsecured $ . 

Less:  Reserve  for  Discount  and  Bad 
Debts 


Stock: 
At  Managers'  Valuation 

Total  Liquid  Assets 

Plant  at  Cost $ . 

Additions  to  31st  December,  1906 

Additions  During  Year 


$ 

Less:  Amount    Written    Off    to 

31st  December,  1906 $ 

Amount  Written  Off  Dur- 
ing the  Year 


Property : 

Freehold  at  Cost $. 

Leasehold  at  Cost $ 

Less:  Written  Off 


Goodwill  as  at 

Accounts  in  Course  of  Extinction 

Preliminary  Expenses $ . 

Less:  Written  Off 


Rates  and  Taxes  Paid  in  Advance. 


(FOBM  35) 


FORM  SUGGESTED  BY  G.  S.  PITT  TO  SOCIETY  OF  INCORPORATED 
ACCOUNTANTS  AND  AUDITORS 


BALANCE  SHEET (date) 


CAPITAL  AND  LIABILITIES: 

Sundry  Creditors: 

Trade  Creditors $ . 

Sundry  Creditors 

Bills  Payable 

Unclaimed  Dividends 

Debentures  (Due  Date) 

Total  Cash  Liabilities 

Capital: 
Authorized S . 


Contingent  Liabilities,  viz.: 


Subscribed  in  Cash $ . 

Less:  Calls  in  Arrears 

Issued  as  Fully  Paid 

Forfeited  Shares  Account 

Investment  Reserve 

Ordinary  Reserve 

Profit  and  Loss 


(Form  35— Concluded) 
487 


FORM  RECOMMENDED  BY  SOCIETY  OF  INCORPORATED^ACCOUN- 
TANTS  AND  AUDITORS  TO  COMMITTEE  OF  PARLIAMENT 

A.  B.  COMPANY  LIMITED 

BALANCE  SHEET, (date) 

ASSETS: 

Fixed  Assets.     Showing: — 

Freehold  Property $ 

Leasehold  Property $ 

Less  Depreciation 


Plant  and  Machinery. 
Less  Depreciation. . 


Fixtures  and  Fittings. 
Less  Depreciation. . 


Goodwill 

Other  Fixed  Assets  (if  any). 


Floating  Assets.     Showing: — 

Cash  in  Bank  and  in  Hand 

Investment  of  Sinking  Fund  (if  any) 

Other  Investments 

Debts  Due  to  the  Company,   Distinguish- 
ing— 

(a)  Debts  on  Bills  Receivable $. 

(b)  Trade  Debts  on  Open  Accounts. ... 

(c)  Other  Debts 

(Any  Debt  Due  by  an  Officer  of  the 

Company  to  be  Separately  Stated) 


Deduct  Reserve   for   Bad  and  Doubtful 
Debts 


Stock-in  Trade 

Other  Floating  Assets  (if  any). 


Nominal  Accounts  .    Showing : — 

Preliminary  Expenses $ . 

Less  amount  written  off 


Insurance,  etc.  Unexpired 

Rents,  Rates  and  Taxes,  etc.,  Paid  in 

Advance 

Items  in  Suspense 

Other  Nominal  Items  (if  any) 


(Form  36) 
488 


FORM  RECOMMENDED  BY  SOCIETY  OF  INCORPORATED  ACCOUN- 
TANTS AND  AUDITORS  TO  COMMITTEE  OF  PARLIAMENT 

A.  B.  COMPANY  LIMITED 

BALANCE  SHEET, (date) 

LIABILITIES: 

Capital  Stock.     Showing: — 
Preferred, 
Authorized,   Shares  at  $ each. ...       $ 

Outstanding  Shares  at  $ each $ 


Common, 

Authorized,    Shares  at  $ each 

Outstanding  Shares  at  $ each 


Liabilities  to  the  Public.     Showing: — 
Specific  Mortgages  (if  not  Deducted  per 

Contra) 

Bonds 


Debts  owing  by  the  Company,  Distinguish- 
ing— 
(a)  Bills  Payable $. 


(b)  Accounts  Payable. 

(c)  Interest  on  Bonds  and  Loans. 

(d)  Unclaimed  Dividends 

(e)  Other  Debts 


Balance.     Consisting  of: — 
General    Reserve,    Including    Bond    Re- 
demption, if  any  (Specific  Reserves  being 
deducted  per  Contra) 

Sinking  Fund  (if  any) 

Forfeited  Shares  Account  (if  any) 

Undivided  Profits 


Contingent  Liabilities 

Claims  against  the  Company  not  Acknowl- 
edged as  Debts,  Moneys  for  which  the 
Company  is  contingently  liable. 


(Form  36 — Concluded) 
489 


AMERICAN  FORM  IN  GENERAL  USE  AMONG  LARGE 
CORPORATIONS 


MODEL  MANUFACTURING  COMPANY 
BALANCE  SHEET 19. . . 

ASSETS: 
Property  Account: 

Balance  at 19 $ 


Construction  and  Purchases  of  Additional  Property 
During  Year 


$. 

Less  Charged  off  to  Following  Accounts : 

$. 
Reserve  for  Depreciation $ 


Goodwill. 


Deferred  Charges  to  Operations: 

(Prepaid  insurance  Taxes,  etc.;  Advanced  Mining 
Royalities  and  Similar  Expanses  Chargeable  to 
Future  Operations) 


Investments: 

Outside  Real  Estate  and  Other  Property $. 

Stocks  of  Other  Companies 

Bonds  of  Other  Companies 


Current  Assets  : 


Inventories 

Bills  Receivable 

Accounts  Receivable. 
Cash. . . . : 


Sinking  and  Special  Fund  Assets: 

(State  Nature  of  Assets  and  Funds  for  which  held $ . 


(FoBM  37) 
490 


AMERICAN  FORM  IN  GENERAL  USE  AMONG  LARGE 
CORPORATIONS 


MODEL  MANUFACTURING  COMPANY 
BALANCE  SHEET 19 

LIABILITIES: 

Bonded  Debt: 

(State  Nature,  Rate  of  Interest  and  Due  Date  of 
Various  Issues  and  Show  Deduction  of  any  Unsold 
Bonds) $ 


$. 

Current  Liabilities  : 

Bills  Payable $ 

Accounts  Payable 

Accrued  Taxes 

Accrued  Interest W 

Miscellaneous 


Reserves  and  Special  Funds  : 

(State  Purpose  and  Amount  of  Each  Reserve  or  Fund . 


Capital  Stock  : 

(If  more  than  One  Class  State  Accordingly $ . 

♦Bond  Sinking  Fund 

Surplus,  as  Annexed 


♦This  is  the  proper  place  for  the  bond  sinking  fund  only  in  the  event  of  it  having 
been  set  up  by  charges  to  profit  and  loss  in  addition  to  adequate  provision  for  deprec  iation 
of  all  wasting  assets.  If  the  sinking  fund  is  permitted  to  take  the  place  of  a  depreciation 
reserve  it  should  be  shown  under  "Reserves  and  Special  Funds." 

(Form  37— Concluded) 
491 


AMERICAN   FORM  USED   BY   FIRMS  AND  INDIVIDUALS 

BIRD  &  GUNN 

BALANCE  SHEET 19 

(for  trading  firm) 


ASSETS: 

Cash  in  Bank  and  on  Hand $ . 

Bills  Receivable 

Accounts  Receivable 

Inventory  of  Merchandise  (at  cost) 

Unexpired  Insurance 

Furniture  and  Fixtures 


LIABILITIES: 

Bills  Payable $. 

Accounts  Payable 

Accrued  Accounts  (Wages,  Interest,  Etc.) 


CAPITAL: 


R.  A.  Bird,  as  annexed. . 
A.  B.  Gunn,  as  annexed. 


(Form  38) 


402 


PROFIT  AND  LOSS  ACCOUNT 

(approved   AMERICAN  FORm) 

Gross  Earnings,  (whether   sales  of  products,  transportation 

earnings,  professional  earnings,  etc.) $, 

DedtLct :    Cost  of  Manufacture  or  Operation : 

(a)  Manufacture  (for  a  Manufacturing  Concern) : 

Labor $ 

Material 

General  Manufacturing  Expenses 

(b)  Cost  of  Operation" (for  Conceiiis  not  Manu- 
facturing) : 

(Under  suitable  headings  according  to  the 
nature  of  the  business) 


Gross  Profits $ . 

Other  Earnings 


$. 

Dedtui^t: 

Expenses  of  sale  (manufacturing  business  only)       $ 

Expenses  of  management  (if  distinct  from  opera- 

ation) 


Net  Profits  from  Operations %. 

Dediict: 

Interest  on  Bonds $ 

Other  Fixed  Charges 


Surplus  for  the  year $. 

Extraordinary  Profits  (detailed) 

Surplus  brought  forward  from  preceding  year 

$. 
Deduct: 

Extraordinary  charges  not  applicable  to  opera- 
tions of  the  year $ 

Interest  and  Dividends  on  Stocks 


Surplus  carried  forward $ . 

(Form  39) 

493 


PROFIT  AND  LOSS  ACCOUNT 
(fob  trading  firm) 

Gross  Sales $ . 

Less:  Returns  and  Allowances $ 

Discounts 

Net  Sales $. 

Inventory  (beginning  of  year) $ 

Purchases 

$ 

Less:  Inventory  (end  of  year) 

Cost  of  Sales 

Gross  Profit $ . 

Selling  and  General  Expenses  (probably  stated  in  some  detail) ... 

Trading  Profit $. 

Interest  (and  other  fixed  charges  not  chargeable  among  selling 
expenses) 


Net  Profit .$. 

Apportioned  between  Partners: 

R.  A.  Bird,  % $ 

A.  B.  Gunn,  H 


<K 


(Form  40) 


494 


STANDARD  FORM  OF  BORROWERS'  STATEMENT 
TO  THE BANK: 

For  the  purpose  of  procuring  credit  from  time  to  time  with  you  for 
our  negotiable  paper  or  otherwise,  we  furnish  the  following  as  a  true  and 

accurate  statement  of  our  financial  condition  on 19 ,  which 

we  may  hereafter  be  considered  as  representing  to  be  a  true  statement  of 
our  financial  condition  unless  notice  of  change  is  given  you. 


ASSETS 


Cash  on  hand  and  in  bank 

Notes  Receivable  of  customers  (not  transferred) 

Accounts  Receivable  of  customers  (not  trans- 
ferred) 

Notes  and  Accounts  Receivable  of    officers 
(not   transferred) 

Merchandise  finished  (how  valued ) 

"  unfinished  (how  valued ) 

"  raw  material      (how  valued ) 

Land  owned  by  corporation,  used  for  this  business 

Buildings  owned  by  corporation,  used  for  this 
business 

Machinery  owned  by  corporation,  used  for  this 
business 


TOTAL 


LIABILITIES 


Notes  Payable  given  for  merchandise 
Notes  Payable  negotiated  to  own  banks 
Notes  Payable  otherwise  disposed  of 
Accounts  Payable 
Deposits  of  Money  with  Us 

Bonded  Debt  (when  due) 

Mortgage  Debt 

Chattel   Mortgages 

Total  Liabiuties 

Capital 

Surplus  including  Undivided  Profits 

TOTAL 


(Form  41) 


495 


STANDARD  FORM  OF  BORROWERS'  STATEMENT 

CONTINGENT  LIABILITY:  Notes  Receivable  of  customers  Discounted 

or  Sold  and  not  included  in  assets  enumerated  above  $ 

Other  contingent  liability $ 

We  Have  Not  Pledged  or  Assigned  any  of  the  above  Accounts  Receiv- 
able; our  Assigned  Accounts  Receivable  amount  to  $ 

Other  assets  used  as  collateral 

INSURANCE:  on  merchandise  $ buildings  $ 

machinery  $ Total  Insurance 

BUSINESS  and  RESULTS:  Annual  Sales  for  the  year  ended 190.... 

or  from 190. ..to 190... 

Gross  Profits  on  Sales  for  the  same  period  $ 

Expense  of  Conducting  Business       "    "      "        " 
Net  Profit  "    "      "        " 

Other  Income  including  investments "    "      "        " 
Combined  Profit  "    "      "        " 

DIVIDENDS  PAID  for  the  period 190... to 190.$ 

BAD  DEBTS  for  the  period 190.. ..to 190.  ..$ 

CAPITAL:  Authorized  $ Issued  $ 

Par  Value  $ per  share 

BANK  ACCOUNTS:  where  kept 

MORTGAGES  and  BONDS  on  what  assets  a  lien 

Average  TERMS  on  which  we  SELL 

Average  TERMS  on  which  we  BUY 

TIME  OF  YEAR  when  NOTES  and  ACCOUNTS  RECEIVABLE  of  CUS- 
TOMERS, Uncollected,  are  generally  maximum 

minimum 

TIME  OF  YEAR  when  STOCKS  of  MERCHANDISE  on  hand  are  generally 
maximum minimum 

TIME  OF  YEAR  when  LIABILITIES  are  maximum 

minimum 

STATEMENT:  is  it  based  on  actual  inventory? 

if  so,  Date 

VERIFICATION:  have  the  books  been  audited  by  a  Certified  Public  Ac- 
countant?  if  so,  Name  and  Date  of  Audit 

(Sign  corporation  name) 


Date  Signed 190  ... 


(Form  41 — Concluded) 
496 


(MUNICIPAL   REPORTS) 

RECEIPTS    CLASSIFIED     BY    CHARACTER    AND    SOURCE,    AND 

BY  DEPARTMENT,  OFFICE,  ENTERPRISE'  OR  ACCOUNT 

A.     Receipts  from  Revenues  and  Accompanying  TemporaryIReceipts 

I.    From  General  Revenues 
(a)  From  Taxes 

General  Property  Taxes  for  Government  of  City 

1.  For  City  Corporation 

2.  For  Other  Independent  Divisions 

For  Other  Civil  Divisions 

3.  For  State 

4.  For  County 

5.  For  Minor  Civil  Divisions 


Special  Property  and  Business  Taxes 


6. 

7. 

8. 

9. 
10. 
11. 
12. 


Poll  Taxes 

13.  For  City  Corporation 

14.  For  Other  Independent^divisions  of  the^Govemment'of  the  City 

15.  For  State 

16.  For  minor  Civil  Divisions 

17.  Total  Taxes 

B.     From  Taxes,  Licenses,  Permits,  Fines,  and  Forfeits 

18.  Total  Taxes 

19.  Liquor  Licenses  and^Other  Imposts 

20.  Other  Business  Licenses 

21.  Dog  Licenses 

22.  General  Licenses 

23.  Departmental  Permits 

24.  Fines  and  Forfeits: 
o.    Penal 

h.     Commercial 

25.  Total  Taxes,  Licenses,  Permits,  Fines,  and  Forfeits 

(Form  42) 
497 


(MUNICIPAL   REPORTS) 

A.     Receipts  from  Revenues  and  Accompanying  Temporary  Receipts — 

Continued 

I.     From  General  Revenues — Continued 

(c)     From  Gifts,  Subventions,  Grants,  and  Miscellaneous  General  Revenues 


26.  Subventions  and  Grants  from  Other  Civil  Divisions: 

a.    From  State,  for  Education 

h.     From  State,  for  Other  Purposes 

c.  From  County,  for  Education 

d.  From  County,  for  Other  Purposes 

e.  Other  Governmental  Grants 

27.  Gifts  from  Individuals  and  Corporations: 

a.    For  Expenses 
6.     For  Outlays 

28.  Miscellaneous  General  Revenues: 

a 

h 

29.  Total  General  Revenue  Receipts 

II.     From  Commercial  Revenues 
id)     From  Special  Assessments  and  Privileges 

30.  Special  Assessments: 

o.  For  Expense 
6.  For  Outlays 
c.     For  Other  Civil  Divisions 

31.  Public  Service  Privileges 

32.  Minor  Privileges 

33.  Total  Special  Assessments  and  Privileges 

(e).     From  Interest 

34.  Interest : 

a.  Sinking  Funds 

6.  Investment  Funds 

c.  Public  Trust  Funds 

d.  Original  Loans 

e.  Current  Deposits 
/.  Deferred  Taxes 

g  .    Deferred  Special  Assessments 

h.     Other  Sources 

i.     Total  Interest  Receipts 


(Form  42 — Continued) 
498 


(MUNICIPAL   REPORTS) 
A.    Receipts  from  Revenues  and  Accompanying  Temporary  Receipts- 

Continued 

II.    From  Commercial  Revenues — Continued 
(/)     From  Municipal  Services  by  Departments,  Offices,  or  Accounts 

/.    General  Government 

35.  Council  and  Legislative  Offices 

36.  Chief  Executive  Offices 

37.  Assessment  and  Collection  of  Revenues 

38.  Other  Finance  Offices  and  Accounts 

39.  Law  Offices 

40.  Miscellaneous  Executive  Offices 

41.  Elections 

42.  Municipal  Buildings 

43.  Courts 

44.  Total  General  Government 


//.     Protection  of  Life  and  Property 

45.  Police  Department 

46.  Fire  Department 

47.  MisceUaneous  Inspection 

48.  Pounds 

49.  Other  Protection  of  Life  and  Property 

50.  Total  Protection  of  Life  and  Property  . .  . . 

///.     Health  Conservation  and  Sanitation 

51.  Health  Department,  Quarantine,  and  Morgue 

52.  Sewers  and  Sewage  Disposal 

53.  Street  Cleaning 

54.  Refuse  Disposal  and  Other  Sanitation 

55.  Total  Health  Conservation  and  Sanitation 

IV.    Highways 

56.  General  Supervision 

57.  General  Street  Services 

58.  Sidewalks 

59.  Bridges,  Other  Than  Toll 

60.  Abolition  of  Grade  Crossings 

61.  Snow  and  Ice  Removal 

62.  Street  Lighting 

63.  Street  Sprinkling 

64.  Miscellaneous 

65.  Total  Highways 

(Form  42 — Continued) 
499 


(MUNICIPAL   REPORTS) 
A.    Receipts  from  Revenues  and  Accompanying  Temporary  Rbceipts- 

Continued 

II.    From  Commercial  Revenues — Continued 

(/)     From  Municipal  Services  by  Departments,  Offices,'^or 
Accounts — Continued 


V.     Charities  and  Corrections 

66.  General  Supervision 

67.  Poor  in  Institutions 

68.  Outdoor  poor  Relief 

69.  Care  of  Children 

70.  Miscellaneous  Charities 

71.  Hospitals 

72.  Insane  in  Institutions 

73.  Prisons  and  Reformatories 

74.  Total  Charities  and  Corrections . 


VI.    Education 


75.  Schools 

76.  Libraries 

77.  Art  Galleries  and  Museums 

78.  Total  Education . 


VII.    Recreation 


79.  Parks,  gardens,  etc 

80.  Baths,  Bathing  Beaches,  etc. 

81.  Celebrations  and  Entertainments 

82.  Total  Recreation . 


VIII.    Miscellaneous  Services 

83.  Miscellaneous  Services 

84.  Total  from  Municipal  Services . . . 


ig)    From  Municipal  Service  Enterprises 

85.    Electric  hght  svstems 

86 

87 

88 

89 

90.  Total  Municipal  Service  Enterprises. . . 

(Form  42 — Continued) 
500 


(MUNICIPAL   REPORTS) 

A.    Receipts  from  Revenues  and  Accompanying  Temporary  Receipts- 

Continued 

II     From  Commercial  Revenues — Continued 

(h)    From  Public  Service  Enterprises 

91.  Water  Supply  Systems 

92.  Electric  Light  Systems 

93.  Gas  Supply  Systems 

94.  Markets  and  Public  Scales 

95.  Docks,  Wharves  and  Landings 

96.  Subways  for  Pipes  and  Wires 

97.  Ferries 

98.  Toll  Bridges 

99.  Cemetaries  and  Crematories 
100.  Institutional  Industries 

101 

102 

103 

104.  Total  Public  Service  Enterprises 

Total  Receipts  from  Revenue  and   Accom- 
panying Temporary  Receipts 


B.    Receipts  from  Municipal  Debt  Obligations  Issued 

105.    a.  General  bonds 

b.  Special  Debt  ObUgations  to  PubUc  Trust  Funds 

c.  Debt  Obligations  to  Other  Civil  Divisions 

d.  Special  Assessment  Bonds 

e.  Revenue  Loans 

/.  Outstanding  Warrants  and  Orders 

g.  Outstanding  judgments 

h.  Miscellaneous  Debt  Obligations 

i.  Total  Receipts  from  Dept  Obligations  Issued. 


C.     Miscellaneous  Temporary  Receipts 

106.  Objects  of  Public  Trust  Funds  for  Non-municipal  usee 

107.  Objects  of  Private  Trust  Funds 

108.  Objects  of  Private  Trust  Accounts 

109.  From  Investments  Disposed  of: 

a.     By  Sinking  Funds 
6.     By  Investment  Funds 

c.  By  Public  Trust  Funds  for  Municipal  Uses 

d.  By  Public  Trust  Funds  for  Non-municipal  Uses 

e.  By  Private  Trust  Funds 

110.  Sales  of  Real  Property 

111.  Damages  to  City  Property 

(Form  42 — Continued) 
601 


(MUNICIPAL   REPORTS) 
C.    Miscellaneous  Temporary  Receipts — Continued 

112.  Refund  Receipts  in  Correction  of  Erroneous  Payments: 

a.  In  Expenses,  P.  1  to  P.  72 

h.  In  Outlays,    P.  1  to  P.  72 

c  .  In  Expenses  of  Public  Service  Enterprises 

d.  In  Outlays  of  Public  Service  Enterprises 

e.  In  Conscience  Money 

/.     In  Losses  by  Defalcation,  etc. 

113.  Total  Temporary  Receipts 


D.     Miscellaneous  Accounting  Credits 

114.  Cash  Transfer  Receipts  of  Independent  Divisions  and  Funds: 

a.     By  City  Corporation from  Sinking  Funds 

h.     By from 

c.  By from 

d.  By from .^ 

e.  By from 

/.     By from 

115.  Depreciation  Service  Transfers 

116.  Minor  Transfer  Receipts 

117.  Other  Accounting  Credits 

118.  Total  Receipts  and  Accounting  Credits 

(Form  42 — Continued) 


5U2 


(MUNICIPAL   REPORTS) 

PAYMENTS     CLASSIFIED     BY  DEPARTMENT,     OFFICE,    ENTER- 
PRISE, OR  ACCOUNT,  AND  BY  OBJECT 
FOR  WHICH  MADE 


A.     Payments  for  Expenses  and  Outlays 
I.     General  Government 

1.  Council  and  Legislative  Offices: 

a.     Council,  Board  of  Aldermen,  etc. 
h.     City  Clerk 

2.  Chief  Executive  Offices: 

a.     Mayor's  Office 

h.     Executive  Boards  and  Commissions 

3.  Finance  Offices  and  Accounts: 

a.     Auditor,  or  Comptroller 
h.     Treasurer,  or  Chamberlain 

c.  Assessment  of  Revenue 

d.  Collection  of  Revenue 

e.  Other  Finance  Offices  and  Accounts 

4.  Law  Offices 

5.  Miscellaneous  Executive  Offices: 

a.     Boards  of  Pubhc  Service 
6.     City  Engineer 

c 

d 

e 

6.  Elections 

7.  Municipal  Buildings 

8.  Courts  and  Court  Officers  : 

a.  General  Municipal  Courts 

h.  Special  Municipal  Courts 

c.  Superior  Courts 

d.  Court  Buildings 

e.  Prosecuting  Officers 
/.  Marshals  and  Sheriffs 

9.  Total  General  Government 


11.     Protection  of  Life  and  Property 

10.  Police  Department: 

a.     General  Expenditures 
h.     Pensions  and  Gratuities 

1 1 .  Militia  and  Armories 

12.  Fire  Department : 

a.    General  Expenditures 
h.     Pensions  and  Gratuities 
c.     Water 

(Form  42 — Continuetl) 
503 


(MUNICIPAL    REPORTS) 
A.     Payments  for  Expenses  and  Outlays — Continued 

II.     Protection  of  Life  and  Property — Continued 

13.  Miscellaneous  Inspection 

14.  Pounds 

15.  Miscellaneous 

a 

h 

c 

d 

16.  Total  Protection  of  Life  and  Property 


III.    Health  Conservation  and  Sanitation 

Health  Conservation 

17.  Health  Department : 

a.     General  Expenditures 
h.     Pensions  and  Gratuities 

18.  Quarantine  and  Contageous  Disease  Hospitals 

19.  Morgues 


Sanitation 


20.  Sewers  and  Sewage  Disposal: 

a.    Supervision 

h.     General  Expenditures 

21.  Street  Cleaning 

22.  Refuse  Disposal 

23 .  Miscellaneous : 


a 

h 

24. 

Total  Health  Conservation 

IV.    Highways 

25. 

General  Supervision 

26. 

General  Street  Expenditures 

27. 

Street  Pavements: 

a.    General  Expenditures 

h.     Renewals 

28. 

Street  Curbing 

29. 

Sidewalks 

30. 

Bridges  Other  Than  Toll 

31. 

Abolition  of  Grade  Crossings 

(Form  42— Continued) 

504 

(MUNICIPAL    REPORTS) 
A,     Payments  for  Expenses  and  Outlays — Contimi ; 
IV.     Highways — Continued. 

32.  Snow  and  Ice  Removal 

33.  Street  Lighting 

34.  Street  Sprinkling 

35.  Miscellaneous 

o 

b 

36.  Total  Highways 

V.    Charities  and  Corrections 

37.  General  Supervision 

38.  Poor  in  Institutions: 

a    Of  City 

b.  Of  Other  Civil  Divisions 

c.  Of  Private  Associations 

39.  Outdoor  Poor  Relief: 

a.  In  City  (direct) 

b.  By  Other  Civil  Divisions 

c.  By  Private  Associations 

40.  Care  of  Children: 

a.  In  City  Institutions 

b.  In  Institutions  of  Other  Civil  Divisions 

c.  In  Private  Institutions 

d.  In  Private  Families 

41.  Miscellaneous  Charities : 

a.  Employment  Agencies 

b.  Soldiers'  Relief 

c 

d 

e 

/ 

9 

42.  Hospitals: 

a.  Of  City 

b.  Of  Other  Civil  Divisions 

c.  Of  Private  Associations 

43.  Insane  in  Institutions : 

a.  Of  City 

b.  Of  Other  Civil  Divisions 

c.  Of  Private  Associations 

44.  Prisons  and  Reformatories: 

a.  Of  City 

b.  Of  Other  Civil  Divisions 

c.  Of  Private  Associations 

45.  Total  Charities  and  Corrections 

(Form  42 — CJontinued) 
605 


(MUNICIPAL    REPORTS) 

A.  Payments  for  Expenses  and  Outlays — Contiuusd 

VI.     Education 

Schools 

46.  General  Supervision 

47.  Elementary  Day  Schools: 

a.  General  Expenditures 

b.  Teaching 

48.  Day  Schools  for  Higher  Education : 

a.  General  Expenditures 

b.  Teaching 

49.  Night  Schools: 

a.  General  Expenditures 

b.  Teaching 

50.  Schools  for  Special  Classes : 

a.  General  Expenditures 

b.  Teaching 

51.  Pensions  and  Gratuities 

52.  Schools  of  Other  Civil  Divisions 

53.  Private  Schools 

54.  Total  Schools 

55.  Libraries 

56.  Art  Galleries  and  Museums 

57.  Total  Education 


VII.     Recreation 

58.  Parks,  Gardens,  etc. : 

a.  General  Supervision 

b.  Buildings  and  Grounds 

c.  Park  Police 

d.  Zoological  Collections 

e.  Public  Playgrounds 
/.  Music  in  Parks 

g.    Trees  in  Streets 

59.  Total  Parks,  Gardens,  etc. . . . 

60.  Baths,  Bathing  Beaches,  etc. 

61.  Celebrations  and  Entertainments 

62.  Miscellaneous : 

a 

b 

c 

63.  Total  Recreation 

(Form  42 — Continued) 
506 


(MUNICIPAL   REPORTS) 
A.     Payments  for  Expenses  and  Outlays — Continued 

VIII.    Miscellaneous 

64.  Miscellaneous  Offices : 

a 

h 

c 

65.  Miscellaneous  Objects: 

a.  Damage  Settlements  and  Judgments 

b.  Losses  by  Defalcation,  Banks,  etc. 
c 

d 

e 

66.  Total  Miscellaneous 

67.  Total  Divisions  I  to  VIII 


IX.     Municipal  Service  Enterprises 
68.     Electric  Light  Systems 

69 

70 

71 

72 ; 

73.  Total  Municipal  Service  Enterprises . 

X.    Public  Service  Enterprises 

74.  Water  Supply  Systems 

75.  Electric  Light  Systems 

76.  Gas  Supply  Systems 

77.  Markets  and  Public  Scales 

78.  Docks,  Wharves,  and  Landings 

79.  Subways  for  Pipes  and  Wires 

80.  Ferries 

81.  ToU  Bridges 

82.  Cemeteries  and  Crematories 

83.  Institutional  Industries 

84 

86 

86.  Total  Public  Service  Enterprises . . . . 


(Form  42 — Continued) 
607 


(MUNICIPAL    REPORTS) 
A,     Payments  for  Expenses  and  Outlays — Continued 

XI.    Expenses  of  Invested  Funds 


87.  Expenses  of  Invested  Funds 

88.  Total  Divisions  IX  to  XI . 

XII.     Interest 


89.  a.  On  Debts  for  General  Purposes 

h.  On  Debts  for  Public  Service  Enterprises 

c.  On  Debts  of  Invested  Funds 

d.  On  Debts  for  Local  Improvements  (Special  Assessments) 

e.  On  Outlay  Accounts 

/.  Total  Interest  Payments 

90.  Total  Payments  for  Expenses  and  Outlays. . 


B.    Payments  op  Municipal  Debt  Obligations 

91.    a.  General  Bonds 

h.  Special  Debt  Obligations  to  Public  Trust  Funds 

c.  Debt  Obligations  to  Other  Civil  Divisions 

d.  Special  Assessment  Bonds 

e.  Revenue  Loans 

/.  Outstanding  Warrants  and  Orders 

g.  Outstanding  Judgments 

h.  Miscellaneous  Debt  Obligations 

i.  Total  Payments  of  Debt  Obligations 


C.    Miscellaneous  Temporary  Payments 

92.  Objects  of  Public  Trust  Funds  for  Non-municipal  Uses 

93.  Objects  of  Private  Trust  Funds 

94.  Objects  of  Private  Trust  Accounts 

95.  For  Investments  purchased: 

a.  By  Sinking  Funds 

6.  By  Investment  Funds 

c.  By  Public  Trust  Funds  for  Municipal  Uses 

d.  By  Public  Trust  Funds  for  Non-municipal  Uses 

e.  By  Private  Trust  Funds 

(Form  42 — Continued) 
508 


(MUNICIPAL   REPORTS) 
C.     Miscellaneous  Temporary  Payments — Continued 

96.  Refund  Payments  in  Correction  of  Erroneous  Receipts: 

a.  In  Subdivisions  (a),  (b),  (c),  (d)  and  (e)  of  Revenue  Receipts 

b.  In  Subdivision  (f)  and  (g)  of  Revenue  Receipts 

c.  In  Subdivision  Qi)  of  Revenue  Receipts 

d.  In  Unspecified  Receipts 

97.  Payments  to  Other  Civil  Divisions: 

a.  To  State,  for  Taxes  ....  $ On  Other  Accounts  $. . 

b.  To  Counties,  for  Taxes On  Other  Accounts    . . 

c.  To  Minor  Civil  Divisions 

for  Taxes On  Other  Accounts     . . 

98.  Total  Miscellaneous  Temporary  Payments  $ . 


D.    Miscellaneous  Accounting  Debits 

99.     Cash  Transfer  Payments  by  Independent  Divisions  and  Funds: 

a.  By  City  Corporation To  Sinking  Funds 

b.  By To 

c.  By To 

d.  By To 

e.  By To 

/.     By To 

100.  Minor  Transfer  Payments 

101.  Other  Accounting  Debits 

102.  Total  Payments  and  Accounting  Debits 

(Form  42 — Concluded) 


APPENDIX  E. 


C.  P.  A.  Examination  Questions. 

Since  the  first  certified  public  accountant  law — that  of  the 
State  of  New  York — was  enacted  in  1896,  many  states,  partic- 
ularly those  in  which  the  larger  cities  of  the  country  are  located, 
have  followed  suit. 

At  this  writing  there  are  nineteen  states  which  have  passed 
C.  P.  A.  laws.  These,  with  the  year  in  which  the  law  was 
enacted,  are: 

1896  New  York  1907  Utah 

1899  Pennsylvania  1907  Colorado 

1900  Maryland  1907  Connecticut 

1 90 1  California  1908  Ohio 
1903  Washington  1908  Louisiana 

1903  Illinois  1908  Georgia 

1904  New  Jersey  1909  Massachusetts 

1905  Michigan  1909  Minnesota 

1905  Florida  1909  Montana 

1906  Rhode  Island 

The  laws  in  all  the  states  excepting  New  York,  Pennsyl- 
vania, Maryland,  New  Jersey  and  Massachusetts  specify  theory 
of  accounts,  practical  accounting,  auditing*  and  commercial  law 
as  subjects  on  which  candidates  shall  be  examined,  and  the 
model  C.  P.  A.  law  submitted  by  the  Committee  on  Legislation 
at  the  1907  annual  meeting  of  the  American  Association  of 
Public  Accountants  likewise  names  these  four  topics  as  the 
subject  of  examination  of  applicants  for  certificates. 

There  has  been  considerable  discussion  as  to  the  desirability 
of  continuing  examinations  under  these  headings,  and  one 


*  The  Colorado  law  specifies  only  theoretical  and  practical  accounting  and  com- 
mercial law,  auditing  not  being  specifically  mentioned,  though  it  would  come  within  the 
scope  of  the  phrase  "such  other  subjects  as  the  Board  may  deem  advisable."  This 
phrase  also  appears  in  the  laws  of  some  other  states. 


APPENDIX  E.  511 

examining  board — that  of  Pennsylvania — now  groups  the  sub- 
jects of  examination  under  two  general  headings,  viz.,  "  Com- 
mercial Law  "  and  "  General  Accounting,"  the  latter  covering 
the  ground,  formerly  divided  among  Theory  of  Accounts, 
Practical  Accounting  and  Auditing.  These  subjects  are  inter- 
related to  such  an  extent  that  it  is  difficult  to  frame  questions 
on  any  one  of  them  which  do  not  overlap  and  the  innovation 
of  the  Pennsylvania  board  has  met  with  general  approval.  It 
has  the  further  advantage  of  enabling  the  examining  board  to 
designedly  frame  questions  which  combine  all  three  of  the 
subjects  in  one  question,  which  is  more  in  accord  with  actual 
facts  and  practical  experience.  The  rules  of  the  Pennsylvania 
State  Board  of  Examiners  of  Public  Accountants  which  have 
been  in  effect  since  January  i,  1907,  are  probably  the  most 
complete  and  set  the  highest  standard  of  any  yet  promul- 
gated. Those  desirous  of  becoming  certified  public  account- 
ants, no  matter  in  what  state  they  expect  to  take  their  exam- 
inations, will  do  well  to  study  these  rules  (published  in  full  in 
the  January,  1907,  Journal  of  Accountancy)  as  they  outline 
in  a  comprehensive  way  the  qualifications  which  the  aspirant 
to  a  C.P.A.  certificate  should  strive  to  acquire. 

To  what  extent  the  fact  that  the  laws  of  those  states,  which 
specify  that  candidates  shall  be  examined  in  theory  of  accounts, 
practical  accounting  and  auditing  would  interfere  with  the  ex- 
aminers in  those  states  following  the  example  of  the  Pennsyl- 
vania board,  the  editor,  of  course,  does  not  pretend  to  say. 
It  is  thought,  however,  that  this  part  of  the  examination  could 
be  stated  as  being  on  "  General  Accounting,  Embracing  the 
Subjects  of  Theory  of  Accounts,  Practical  Accounting  and 
Auditing." 

The  necessity  for  a  broader  general  education  and  more 
scientific  preparation  for  a  professional  career,  as  distinguished 
from  the  narrow  technical  accomplishments  which  were  at  first, 
when  accompanied  by  a  good  moral  character,  considered  suffi- 
cient to  entitle  the  applicant  to  practice  as  a  certified  public  ac- 
countant, is  now  recognized.    It  should  be  said  to  the  credit  of 


$12  AUDITING. 

New  York  that  it  early  recognized  the  importance  of  a  good 
general  education  and  required  the  equivalent  of  a  high  school 
education.  Some  of  the  later  laws  include  such  a  requirement, 
while  in  still  other  cases  the  examining  boards  are  making  it  a 
prerequisite  to  taking  the  technical  examinations. 

Future  development  along  the  line  of  testing  the  qualifica- 
tions of  applicants  for  C.P.A.  certificates  will  doubtless  result 
in  the  division  of  the  examination  into  two  sections,  a  prelim- 
inary and  a  final.  This  step  has  already  been  taken  by  the 
Pennsylvania  board,  which  subjects  the  candidates  to  a 

Preliminary  Examination  "  intended  as  a  test  of  the 
candidates'  general  fitness  for  the  study  of  accountancy." 
In  the  absence  of  having  had  a  general  education  of  high 
school  grade,  the  appHcant  is  examined  on  the  subjects 
found  in  a  high  school  curriculum ;  and  all  candidates  are 
examined  in  the  "  History  of  Accountancy  "  and  "  Ele- 
mentary Principles  of  Accounts," 

and  a 

Final  Examination, .  in  "  Commercial  Law,"  and  "  Gen- 
eral Accounting,"  to  which  reference  has  already  been 
made. 

The  question  of  an  experience  requirement  for  applicants 
for  certificates  is  also  receiving  much  attention  and  considera- 
tion. It  is  becoming  recognized  that  it  is  essential  that  one 
must  have  had  some  experience  in  the  practical  application  of 
the  theory  he  has  studied  or  been  taught  in  schools  before 
he  can  really  be  qualified  to  hold  himself  out  to  the  public  as 
one  who  on  examination  by  the  proper  authorities  has  been 
skilled  in  the  practice  of  accountancy.  Some  of  the  examin- 
ing boards  have  already  prescribed  an  experience  requirement 
and,  without  doubt,  it  will  in  time  become  general. 

Included  in  this  appendix  are  the  questions  on  "  Auditing  " 
submitted  at  recent  examinations  in  a  number  of  different 
states.    These  give  a  fair  idea  of  the  scope  of  the  subject  of 


APPENDIX  E.  513 

this  work  from  the  viewpoint  of  the  examining  Soards.  The 
Pennsylvania  questions  are  on  "  General  Accounting  "  and  in- 
clude questions  which  are  not  strictly  on  auditing,  but  they 
are  given  in  full  that  the  superiority  of  this  manner  of  treat- 
ment may  be  seen  by  those  studying  the  questions. 

PENNSYLVANIA. 

Examinations  held  November  23  and  24,  1908. 

( 1 )  State  the  more  important  points  of  the  national  banking 
system  relating  to  the  formation  of  banks,  responsibilities  of 
directors  and  the  general  requirements  as  to  the  scope  and 
conduct  of  the  business. 

(2)  The  Safe  Trust  Company  has  the  following  depart- 
ments : 

Banking, 
Corporate  Trust, 
Individual  Trust, 
Registration  and  Transfer 
Safe  Deposit. 

(i)  Describe  the  various  classes  of  business  conducted 
in  (a)  the  Corporate  Trust  Department  and  (b)  the  Indi- 
vidual Trust  Department. 

(2)  Outline  the  accounting  system  you  would  recom- 
mend for  the  business  of  these  two  departments  (assum- 
ing that  the  gross  assets  in  each  were  $75,000,000  and 
$30,000,000  respectively)  and  describe  the  principal  books 
you  think  should  be  used. 

(3)  Prepare  a  balance  sheet  as  of  September  30,  1908, 
for  these  two  departments,  showing  captions,  but  omitting 
amounts. 

(3)  Describes  the  functions  and  method  of  operation  of  a 
stock  exchange  clearing  house,  and  points  out  the  differences 


5  1 4  AUDITING. 

between  a  stock  exchange  clearing  house  and  a  bank  clearing 
house. 

(4)  In  auditing  the  accounts  of  a  firm  of  stockbrokers  how 
would  you  verify  the  accounts  relating  to  bonds,  stocks  or  other 
securities  owned  by  the  firm  or  carried  for  account  of  custom- 
ers or  others. 

(5)  You  are  asked  to  audit  the  accounts  of  the  Universal 
Fire  Insurance  Company  at  December  31,  1908,  and  furnish  a 
certificate  to  be  published  in  connection  with  the  balance  sheet 
of  the  company.  To  what  matters  more  or  less  peculiar  to  a 
fire  insurance  company  should  your  attention  be  directed  and 
how  would  you  deal  with  each  one  ? 

(6)  The  Valley  Manufacturing  Company  operates  an  ex- 
tensive machine  shop  in  the  manufacture  of  sewing  machines 
of  which  they  produce  a  number  of  types.  From  time  to  time 
the  company,  through  improvements  designed  in  its  experi- 
mental department,  is  able  to  produce  new  types  of  sewing 
machines  or  parts  thereof.  In  bringing  out  a  new  type  it  is 
first  necessary  to  make  or  buy  a  quantity  of  new  machine  tools, 
such  as  jigs,  dies,  etc.,  at  a  cost  of  say  $5,000.  These  new 
types  of  sewing  machines  are  brought  out  at  irregular  inter- 
vals averaging  perhaps  eighteen  months  apart.  The  machine 
shop  contains  a  large  variety  of  machines  ranging  in  cost  from 
$150  each  to  $2,500  each.  In  addition  to  its  sales  of  completed 
machines  the  company  sells  large  quantities  of  parts  for  pur- 
poses of  repairs. 

You  are  retained  to  devise  and  instal  a  system  of  cost  ac- 
counts that  will  show  as  accurately  as  possible  the  cost  not 
only  of  a  complete  sewing  machine,  but  also  of  each  one  of  its 
component  parts. 

Omitting  a  description  of  the  portions  of  your  cost  system 
relative  to  materials  and  productive  labor,  explain  how  you 
would  deal  with  (a)  the  problem  of  ascertaining  the  costs  of 
individual  parts,  (b)  the  ascertainment  and  distribution  of  the 


APPENDIX  E.  515 

general  expenses  of  the  factory  frequently  known  as  the  "shop 
burden,"  and  (c)  the  disposition  to  be  made  of  the  cost  of 
special  jigs,  dies  and  other  machine  tools  acquired  for  the  pro- 
duction of  improved  types  of  sewing  machines  or  parts  thereof. 

(7)  Form  a  trial  balance  of  a  manufacturing  concern,  either 
corporation,  partnership,  or  individual,  with  which  you  are 
acquainted,  and  prepare  therefrom  a  statement  giving  the  re- 
sults of  operation,  and  a  final  balance  sheet.  Write  a  report 
dealing  with  the  conditions  of  the  business  and  commenting 
on  the  managerial  results,  volume  of  expenses,  etc. 

(8)  By  the  partnership  deed  of  a  manufacturing  firm  con- 
sisting of  four  members,  A.,  B.,  C,  and  D.,  it  was  provided 
that  in  the  event  of  the  death  of  any  partner  before  the  expira- 
tion of  the  partnership  on  December  31,  1909,  there  should  be 
paid  to  the  legal  representatives  of  the  deceased  partner  the 
amount  appearing  to  his  credit  on  December  31,  next  preceding 
the  death,  together  with  interest  thereon  at  5  per  cent,  per 
annum,  to  December  31  following  the  date  of  decease,  and  a 
share  of  the  profits  of  the  year  of  his  decease  corresponding  to 
the  number  of  days  that  he  lived  during  it,  calculated  after  the 
rate  of  the  average  of  his  share  for  the  last  three  completed 
years.  The  four  partners  shared  profits  equally,  and  each  took 
interest  on  his  capital  at  5  per  cent,  per  annum,  but  no  interest 
was  charged  on  the  drawings.  The  surviving  partners  were  to 
share  the  profits  equally.  C.  died  on  June  30,  1907.  The 
profits  of  the  three  immediately  preceding  years  had  been  re- 
spectively $70,000,  $78,000  and  $65,000.  From  the  following 
trial  balance  of  December  31,  1907,  prepare  manufacturing  and 
profit  and  loss  accounts  for  1907,  allowing  $2,500  for  deprecia- 
tion of  plant,  and  $250  for  depreciation  of  office  fixtures  and 
furniture.  Also  construct  a  balance  sheet  showing  the  interest 
of  the  remaining  partners  and  treating  the  amount  owing  to 
the  estate  of  C.  as  a  liability  of  the  firm.  In  preparing  this 
balance  sheet  follow  the  form  you  prefer  and  group  the  items 
in  accordance  with  your  best  judgment. 


5  I'6  AUDITING. 

Trial  Balance — December  31,   1907. 

A,  Capital  Account  ]  $120,000.00 

B,  "             "        1  No  change  in  partners'  capital  ac-  110,000.00 

C,  "             "        j      counts  during  year  1907.  100,000.00 

D,  "             "       J  90,000.00 

A,  Drawing  Account $12,000.00 

B,  "              "       12,000.00 

C,  "              "       5,000.00 

D,  "              "       12,000.00 

Stock  December  31,  1906 $100,000.00 

(Note:     Stock  at  December  31,  1907 

was  $125,000.00) 

Purchases  during  Year $1,775,000.00 

Factory  Wages  and  Salaries 250,000.00 

Discount  received  and  allowed,  balance 

of 20,000.00 

Sales  during  the  year 2,110,000.00 

Cash  in  hand  and  at  bank 29,500.00 

Bad  Debts 16,000.00 

Bills  Receivable  in  hand 15,000.00 

Office  Salaries 9,000.00 

Office  Expenses,  General 2,500.00 

Sundry  Debtors 414,000.00 

Traveling  Expenses 10,000.00 

Insurance 1,000.00 

Office  Rent,  Taxes,  etc 2,000.00 

Real  Estate— Factory 60,000.00 

Factory  Plant 15,000.00 

Office  Fixtures  and  Furniture 2,500.00 

Bills  Payable 50,000.00 

Sundry  Creditors  on  Open  Accounts. . . .  150,000.00 

Interest  paid 7,500.00 


$2,750,000.00     $2,750,000.00 


(9)  You  are  retained  by  an  industrial  company  to  make 
such  an  examination  of  its  accounts  as  will  enable  you  to 
certify  to  its  balance  sheet  at  December  31,  1908,  the  object  ot 
the  company  being  to  aid  it  in  selling  its  notes  through  note 
brokers. 

Give  an  outline  of  your  method  of  procedure,  showing  the 
extent  to  which  you  would  consider  it  necessary  to  carry  your 
examination  in  respect  to  the  several  classes  of  assets  and 
liabilities. 

Assuming  that  you  are  satisfied  to  give  a  certificate  to  the 
balance  sheet,  in  what  form  would  you  express  it? 


APEXDIX    E.  517 

(10)  A  coal  mining  company  "A,"  desires  to  acquire  an- 
other smaller  mining  corporation  **B,'  the  capital  stock  of 
which  is  $ioo,cxx).  It  purchases  the  entire  capital  stock  for 
$300,000,  and  in  order  to  obtain  the  funds,  borrows  that 
amount,  giving  five  notes  due  in  one,  two,  three,  four  and  five 
years,  for  $60,000  each,  and  bearing  interest  at  the  rate  of  6 
per  cent,  per  annum. 

Company  "B"  owns  no  real  estate,  but  operates  under  a  lease 
which  will  expire  fifteen  years  after  the  date  of  the  above 
mentioned  purchase.  At  the  termination  of  the  lease,  all  per- 
manent improvements,  buildings,  etc.,  other  than  movable 
equipment,  becomes  the  property  of  the  lessor. 

At  the  time  of  the  purchase  it  is  found  that  the  current  or 
liquid  assets  of  company  "B,"  other  than  the  investment  in 
buildings  and  equipment,  amount  to  $50,000.  It  is  also  neces- 
sary to  expend  $10,000  per  annum  for  the  first  two  years  in  the 
erection  of  permanent  buildings  in  addition  to  the  ordinary 
charges  for  maintenance. 

It  is  required  that  the  stock  of  company  "B"  shall  be  worth 
par  at  the  termination  of  the  lease.  It  is  further  desired  that 
interest  on  the  notes  given  by  "A"  should  be  extinguished  by 
the  income  received  from  "B,"  and  also  that  the  investment  of 
"A,"  except  as  represented  by  the  par  value  of  the  stock  of 
company  "B"  should  be  extinguished  before  the  termination 
of  the  lease. 

Both  companies  are  to  be  operated  entirely  independently  of 
each  other  and  the  only  connection  is  through  that  of  stock 
ownership. 

The  reply  to  this  question  should  be  in  the  nature  of  a  clear 
and  concise  plan,  stating  how  these  transactions  should  be 
treated  on  the  books  of  both  companies.  Include  with  this  a 
set  of  ledger  accounts  illustrating  the  workings  of  the  plan 
you  would  recommend. 


Sl8  AUDITING. 

(ii)  A  book  publishing  company  has  brought  out  its  first 
book.  Plates  capable  of  100,000  impressions  cost  $20,000; 
composition,  proof  reading,  etc.,  cost  $6,000;  the  author  is  to 
receive  a  royalty  of  25  cents  per  volume  on  the  books  sold.  As 
a  first  edition,  20,000  books  are  printed  at  a  labor  cost  of 
$2,000,  and  a  further  charge  of  $1,500  to  cover  the  proportion 
of  general  expenses.  At  the  end  of  the  year  10,000  copies  had 
been  sold  for  $20,000.  How  would  you  prepare  the  accounts 
under  the  following  conditions? 

(i)  If  it  were  ascertained  that  the  demand   for  the 
book  had  practically  ceased. 

(2)   If  a  steady  demand  would  continue  until  the  plates 
were  worn  out. 

(12)  The  B.  &  E.  Company  is  a  wholesale  trading  concern, 
having  its  headquarters  in  Lancaster,  Pa.,  and  maintaining 
branch  stores  in  a  number  of  cities,  Richmond,  Va.,  among 
others.  These  branch  stores  receive  their  goods  upon  consign- 
ment from  the  head  office;  keep  the  accounts  with  their  cus- 
tomers; make  collections  thereon;  keep  local  bank  accounts; 
pay  current  expense  bills  and  remit  their  excess  funds  from 
time  to  time  to  the  head  office.  The  manager  of  the  Richmond 
branch  is  employed  on  a  small,  fixed  salary,  and  a  commission 
based  on  the  sales,  the  latter  compensation  being  forwarded 
to  him  quarterly  by  check  from  the  Lancaster  office.  Without 
intending  to  steal  he  adopted  the  habit  of  anticipating  the  ar- 
rival of  his  check  and  withheld  collections  received  from  cus- 
tomers, making  no  entries  therefor  upon  the  books  for  the  time 
being,  but  being  careful,  however,  not  to  hold  out  any  one  item 
longer  than  a  few  days,  thus  constantly  replacing  out  of  the 
current  receipts  items  previously  withheld.  Upon  receipt  of 
his  quarterly  check  for  commissions  he  would  at  once  make 
good  the  amount  he  had  in  the  above  manner  advanced  from 
the  company's  funds  to  himself. 


APPENDIX  E.  519 

(a)  If  you  were  instructed  to  audit  the  accounts  of 
the  B.  &  E.  Company,  including  those  of  the  branch  offices, 
would  your  audit  disclose  this  condition,  and,  if  so,  con- 
cisely and  carefully  describe  the  course  you  would  pursue. 

(b)  What  criticisms  have  you  to  offer  relative  to  the 
administrative  plan  of  the  B.  &  E.  Company  as  outlined 
above  ? 

(c)  Describe  clearly  the  form  of  accounts  you  think  is 
best  adapted  to  this  business  if  it  were  operated  in  accord- 
ance with  the  methods  best  suited  in  your  judgment  for 
the  management  of  a  business  maintaining  branch  stores. 

(13)  A  wool  merchant  has  entered  into  an  agreement  to 
take  1,000,000  pounds  of  wool,  in  the  grease,  on  joint  account 
with  the  shipper,  to  have  it  washed,  scoured,  combed,  etc.,  and 
sell  the  product;  the  profit  or  loss  to  be  shared  equally. 

The  grease  wool  is  sent  to  the  scourer  in  lots  as  received 
from  the  shipper  and  returned  from  day  to  day  in  smaller 
quantities  as  grades  A  B,  C,  D  and  E;  these  lots  (or  some  of 
them)  and  combinations  of  said  lots  are  sent  to  combers  and 
again  returned  in  smaller  quantities  from  day  to  day  as  grades 
Nos.  I,  2,  3,  4,  and  5. 

The  wool  may  be  sold  in  any  form  that  is  in  the  grease,  as 
grade,  A,  B,  C,  D,  and  E,  or  as  grades  Nos.  i,  2,  3,  4  and  5. 

It  will  be  necessary  for  the  merchant  to  report  the  results  of 
the  transactions  in  each  lot  separately. 

Submit  a  method  for  keeping  a  record  of  this  stock  and 
accounts  from  which  proper  statements  can  be  made  to  the 
shipper  showing  the  loss  in  the  various  processes,  the  quantities 
sold,  to  whom,  prices,  etc.,  and  the  net  loss  or  gain. 

(14)  What  are  the  present  requirements  of  the  Interstate 
Commerce  Commission  relative  to  the  treatment  of  deprecia- 
tion in  the  accounts  and  reports  of  railroad  companies? 


520  AUDITING. 

(15)  Three  railway  lines,  "A"  Ry.  Co.,  "B"  Ry.  Co.,  and 
"C"  Ry.  Co.,  all  of  the  stocks  of  which  are  owned  by  a  holding 
company,  enter  into  an  agreement  of  consolidation  and  merger 
under  the  name  of  the  C.  Ry.  Co.  New  stock  is  issued  to  the 
holding  company  in  exchange  for  the  old  stock,  on  a  basis  of 
share  for  share.  And  it  is  further  agreed  that  sufficient  addi- 
tional new  stock  shall  be  issued  and  sold  at  par  to  the  holding 
company  for  the  purpose  of  redeeming  the  bonds  of  "A"  and 
"C*  and  paying  the  interest  accrued. 

Following  are  balance  sheets  of  the  three  companies.  Ac- 
cept values  as  stated  and  prepare  a  balance  sheet  of  the  con- 
solidated company  after  all  transactions  incident  to  the  merger 
are  completed.  In  setting  up  the  balance  sheet  do  so  with  a 
view  to  the  fact  that  none  of  the  companies  have  made  very 
liberal  provision  for  the  depreciation  of  their  road  and  equip- 
ment. 

BALANCE  SHEET  —"A"   RAILWAY  CO. 

Assets. 

Road  and  Equipment $600,000.00 

Material  and  Supplies 5,000.00 

Accounts  Receivable 2,000.00 

Bills  Receivable  owing  from  " B"  Rwy.  Co . . .  15,000.00 

Bills  Receivable  owing  from  "C"  Rwy.  Co. .  2,000.00 

Cash 1,000.00 

Cash  and  Bonds  in  hands  of  Trustee  of  Sink- 
ing Fund  for  1st  Mortgage  Bonds 30,000.00 

Total  Assets $655,000.00 


Liabilities. 

Capital  Stock $300,000.00 

First  Mortgage  Bonds 250,000.00 

Accounts  Payable 10,000.00 

Sinking  Fund— First  Mortgage  Bonds 30,000.00 

Accrued  Interest  on  Bonds 6,250.00 

Profit  and  Loss 58,750.00 

Total  Liabilities $655,000.00 


APPENDIX  E.  521 

BALANCE   SHEET— "B"   RAILWAY  CO. 

Assets. 

Road  and  Equipment $250,000.00 

Material  and  Supplies 1,000.00 

Accounts  Receivable 1,000.00 

Cash 1,000.00 

Profit  and  Loss 62,000.00 

Total  Assets $315,000.00 

Liabilities. 

Capital  Stock $300,000.00 

Bills  Payable 15,000.00 

Total  Liabilities $315,000.00 


BALANCE  SHEET— "C"   RAILWAY  CO. 

Assets. 

Road  and  Equipment $1,500,000.00 

Material  and  Supplies 10,000.00 

Accounts  Receivable 10,000.00 

Cash 15,000.00 

Cash  and  Bonds  in  hands  of  Trustee  of 

Sinking  Fund  for  1st  Mtge  Bonds 100,000.00 

Total  Assets $1,635,000.00 

Liabilities. 

Capital  Stock $1,000,000.00 

First  Mortgage  Bonds 500,000.00 

Bills  Payable 2,000.00 

Sinking  Fund  1st  Mortgage  Bonds 100,000.00 

Accrued  Interest  on  Bonds 12,500.00 

Profit  and  Loss 20,500.00 

Total  Liabilities $1,635,000.00 


(16)  In  municipal  affairs  what  is  the  purpose  of  a  budget? 
What  relation  does  it  bear  to  the  accounting  of  a  municipality  ? 

(17)  Make  out  for  an  intending  purchaser  a  report  of  an 
examination  made  by  you  of  a  gas  company,  street  railway 


522  APPENDIX  E. 

or  electric  lighting  company,  whichever  you  are  most  familiar 
with,  covering  in  your  report  all  points  relating  to  the  prop- 
erty and  the  accounts  which  are  necessary  for  an  intending 
purchaser  to  know,  including  not  only  matters  divulged  by 
your  examination,  but  referring  briefly  to  the  contents  of  re- 
ports made  by  other  experts  upon  examinations  made  by  them 
at  or  about  the  same  time  as  your  own,  but  dealing  with 
affairs  outside  the  field  of  accounting. 

(i8)  You  are  instructed  by  the  receiver  of  an  importing 
and  trading  concern  to  examine  the  accounts  and  report  to  him 
upon 

(a)  the  financial  position  of  the  concern,  and 

(b)  the  causes   that  have  mainly  contributed  to   the 
failure. 

In  your  answer  prepare  a  statement  of  the  assets  and  lia- 
bilities in  such  form  as  you  think  should  be  used  for  the 
information  of  the  receiver  and  the  creditors  and  under  (b) 
state  the  matters  to  which  you  would  direct  your  attention, 
having  in  mind  the  nature  of  the  business,  and  how  you  would 
proceed  with  your  investigation. 

NEW  YORK. 

Examination  held  June  24,  1908. 

(i)  In  the  preparation  of  a  manufacturing  and  trading 
account  and  a  balance  sheet,  state  on  what  basis  the  following 
assets  should  be  valued : 

(a)  Raw  materials. 

(b)  Product  in  process  of  manufacture. 

(c)  Manufactured  product. 

(d)  Bills  receivable. 

(e)  Accounts  receivable. 

Give  fully  your  reasons. 


APPENDIX  E.  523 

(2)  In  preparing  a  statement  of  the  earnings  of  a  business, 
covering  a  period  of  five  years,  how,  in  order  to  determine 
what  the  average  earning  capacity  of  said  business  has  been, 
should  the  expenditure  for  interest  paid  on  bills  payable  and 
loans,  and  on  accounts  payable  be  considered? 

(3)  An  examination  of  the  minutes  and  other  records  of 
the  books  of  a  corporation,  preceding  an  audit,  discloses  that  a 
revaluation  of  its  buildings,  plant,  and  machinery,  had  been 
made  by  expert  appraisers  called  in  for  the  purpose.  The 
report  of  these  appraisers  states  that  the  values  as  determined 
by  them  were  greater  than  those  shown  on  the  books.  Should 
such  increased  value  be  entered  on  the  books  of  the  corpora- 
tion ?  What  entries  should  be  made  to  show  this  in  the  profit 
and  loss  account  and  balance  sheet? 

(4)  What  kind  of  expenditures  of  a  manufacturing  business 
would  you  classify  as  being  in  the  nature  of  maintenance  and 
repairs  of  equipment,  machinery,  and  plant,  and  what  would 
constitute  actual  betterments  ?  How  should  such  expenditures 
be  dealt  with  on  the  books  and  shown  in  the  profit  and  loss 
statement,  and  on  the  balance  sheet? 

(5)  Define  and  differentiate  an  audit  conducted  for  the 
purpose  of  reviewing  past  transactions  and  establishing  the 
significance  thereof  and  an  audit  precedent  to  determining  the 
verity  of  a  bill  or  of  a  claim.  Give  a  brief  outline  of  the  pro- 
cedure in  each  case. 

(6)  State  (a)  for  what  class  of  assets  provision  for  depre- 
ciation should  be  made,  (b)  what  would  constitute  an  adequate 
rate  for  depreciation  on  buildings  and  on  plant  and  machinery 
respectively.     Give  reasons. 

(7)  How  should  a  leasehold  be  treated  in  the  accounts  of 
a  company,  and  how  should  it  be  shown  on  the  balance  sheet? 

(8)  Give  a  brief  description  of  the  books  of  a  corporation 
that  should  be  examined  and  inspected  by  the  auditor,  and  state 


524  AUDITING. 

the  reasons  why  such  examination  or  inspection  should  be 
made. 

(9)  What  is  the  value  of  a  bank  pass-book  for  the  purpose 
of  an  audit?  How  would  you  reconcile  the  pass-book  balance 
with  the  cash  book  balance  ? 

(10)  In  auditing  an  account  the  auditor  finds  that  Robert 
Brown  had  bought  a  bill  of  goods  amounting  to  $500  payable 
on  August  ID,  less  2  per  cent.  He  had,  however,  made  pay- 
ments thereon  as  follows: 

June    2 $100 

June  15 100 

July     3 100 

On  what  date  would  he  be  required  to  make  payment  of 
the  remaining  $200  to  entitle  him  to  the  2  per  cent,  discount 
under  the  original  terms  of  sale? 

(11)  What  generally  constitutes  capital  expenditure  ?  What 
expenditures  are  properly  chargeable  against  revenue?  Ex- 
plain and  give  illustrations  in  each  case. 

(12)  The  accounts  of  a  steel  and  iron  manufacturing  com- 
pany show  large  additions  to  plant  and  machinery.  It  is 
found  that  these  charges  include  considerable  amounts  from 
pay-rolls.  In  the  absence  of  specific  explanations  as  to  the 
pay-roll  element,  what  method  should  be  employed  by  the 
auditor  to  determine  the  accuracy  and  the  propriety  of  these 
charges  ? 

(13)  If  the  auditor  has  not  verified  or  had  opportunity  to 
verify  the  actual  cash  on  hand  at  the  date  of  the  balance  sheet 
what  should  be  his  procedure  to  prove  the  correctness  of  the 
balance  sheet  as  stated,  before  giving  his  certificate? 

(14)  In  auditing  the  accounts  of  a  railway  company  how 
should  the  auditor  determine  whether  or  not  the  net  earnings 
are  correctly  stated? 


APPENDIX  E.  525 

(15)  What  test  of  the  prime  cost  of  manufactured  goods 
should  be  made  to  guard  against  loss  of  raw  material  through 
theft  by  employees? 

ILLINOIS. 

Examination  held  May  4,  1908. 

(i)  In  a  case  where  preferred  shares  of  a  company  are 
issued  under  a  provision  that  the  annual  dividends  to  which 
they  shall  be  entitled  shall  be  "  cumulative,"  would  you  con- 
sider it  necessary  to  show  any  arrears  of  dividend  as  a  liability 
upon  the  balance  sheet,  or  how  would  you  deal  with  it? 

(2)  What  special  points  in  the  balance  sheet  of  a  com- 
pany, aside  from  the  correctness  of  the  figures  require  careful 
consideration  by  the  auditor? 

(3)  In  making  an  audit  of  the  accounts  of  a  corporation, 
would  you  consider  it  part  of  your  duty  to  verify  the  trans- 
fers of  the  certificates  of  capital  stock  occurring  during  the 
period  covered  by  your  examination  ? 

(4)  In  financing  a  manufacturing  company  it  is  considered 
necessary  to  arrange  for  an  issue  of  $300,000  first  mortgage 
5  per  cent.  20-year  bonds ;  $500,000  6  per  cent,  non-cumulative 
preferred  stock,  which  may  be  retired  any  time  after  five  years, 
and  $1,000,000  common  stock.  The  bonds  are  disposed  of 
at  90  per  cent,  of  their  face  value  and  proceeds  used  for  erect- 
ing buildings  and  purchase  of  machinery  and  equipment. 

The  preferred  stock  is  sold  at  85  and  one  share  of  common 
stock  is  given  with  each  share  of  preferred  stock,  the  common 
stock  remaining  being  disposed  of  at  40.  How  would  you 
deal  with  the  discount  in  each  case? 

(  5 )  A  company  whose  capital  stock  is  $250,000,  divided  into 
$100,000  6  per  cent,  non-cumulative  preferred  shares,  and 
$150,000  common  shares,  begins  its  life  with  an  excess  of  lia- 
bilities over  real  assets  to  the  extent  of  $10,500,  which  sum  is 
debited  to  suspense  account.     During  the  first  few  years  small 


526  AUDITING. 

losses  are  made  and  carried  forward  on  the  profit  and  loss  ac- 
count but  finally  sufficient  profits  are  earned  to  wipe  out  the 
losses  of  the  previous  years  and  leave  a  balance  of  $16,500. 

The  holders  of  the  preferred  stock  claim  that  any  surplus 
profit,  after  payment  of  the  preference  dividend,  should  be 
used  to  extinguish  the  suspense  account. 

The  holders  of  the  common  stock  claim  that  all  of  such  sur- 
plus is  properly  available  for  their  dividend  on  the  ground  that 
the  original  deficiency  carried  to  suspense  account  was  in  effect 
a  charge  to  goodwill. 

Give  briefly  your  understanding  of  "  goodwill."  State  how 
you  would  deal  with  it  in  this  case,  and  whether  the  directors 
may  pay  any  dividend  on  the  common  stock. 

(6)  A  suburban  traction  company,  after  equipping  its  line  at 
a  very  considerable  expense  for  overhead  trolley,  and  operating 
same  for  several  years,  decides  to  adopt  the  third-rail  system. 
Extensive  changes  are  necessary  in  changing  power  houses, 
re-arranging  tracks,  and  altering  cars,  involving  an  expendi- 
ture of  $25,000.  In  addition  considerable  machinery  and  roll- 
ing stock,  the  original  cost  of  which  had  been  treated  as  a 
capital  outlay  and  was  carried  on  the  books  at  a  valuation  of 
$25,000,  is  rendered  obsolete,  and  is  disposed  of  for  $3,500, 
showing  a  loss  of  $21,500.  The  profits  from  operation  for 
the  year  $18,000. 

State  how  you  would  recommend  that  the  matter  be  dealt 
with  in  the  company's  accounts,  and  whether  the  company  can 
pay  a  dividend? 

(7)  A  firm  having  several  branches  maintains  an  account 
with  each  branch  in  the  ledger  and  charges  to  such  account  all 
goods  sent  to  the  agents  for  stock.  When  stock  is  taken  the 
balance  of  each  branch  account  is  treated  as  ordinary  accounts 
receivable  and  is  included  in  the  general  debts  owing  to  the 
firm.  If  you  see  any  objections  to  this  method,  state  them, 
and  say  how  you  would  deal  with  the  accounts. 


APPENDIX  E.  527 

(8)  Presuming  that  upon  examination  of  a  merchant's  ac- 
counts the  balance  shown  by  the  bank  pass-book,  or  certified 
by  the  bankers,  agreed  with  the  balance  shown  in  the  mer- 
chant's cheque-book,  would  you  consider  any  further  examina- 
tion necessary? 

State  reasons  for  your  reply. 

(9)  Define  your  understanding  of  principle  involved  in  de- 
termining what  are  and  what  are  not  expenditures  from  capital. 

(10)  You  are  instructed  to  make  an  audit  by  a  merchant 
selling  finished  goods,  or  by  a  manufacturer.  State  all  your 
responsibilities.  Name  the  financial  statements  you  should 
make  and  give  a  form  of  certificate. 

CALIFORNIA. 

Examination  held  May  28,  1908. 
(Part  of  questions  only.) 

( 1 )  State  the  different  kinds  of  audits  and  describe  them. 

(2)  What  would  be  required  from  a  firm  or  corporation  by 
an  auditor  before  entering  upon  the  audit  of  the  books? 

( 3  )  In  making  the  first  periodical  audit  of  a  corporation  that 
had  personally  taken  over  the  business  of  a  firm,  what  would 
you  include  in  your  examination  beside  the  usual  books  and 
accounts,  and  for  the  purpose  of  ascertaining  what  facts? 

(4)  From  the  information  gathered  and  noted  throughout 
an  audit,  what  matters  would  you  call  especial  attention  to, 
and  what  schedules  and  statistical  statements  would  you  furn- 
ish the  client? 

(5)  What  constitutes  capital  expenditure? 

(6)  Would  an  auditor  be  justified  in  certifying  to  the  accu- 
racy of  accounts  in  which  such  expenditure  appeared  without 
making  inquiry  into  the  real  character  of  same.  If  not,  why 
not?   If  he  would,  why? 


$28  APPENDIX  E. 

W^ASHINGTON. 

Examination  held  August  7,  1908. 

(i)  What  are  the  responsibilities  of  an  auditor  and  what 
should  be  his  qualifications? 

(2)  (a)  Give  some  reasons  why  a  firm  or  corporation 
should  have  periodical  audits. 

(b)  What  advantage  has  a  firm  or  corporation  in  em- 
ploying a  Certified  Public  Accountant  for  the  work  ? 

(c)  How  far  should  an  auditor  enquire  into  the  work 
of  his  predecessor. 

(3)  Draw  up  a  form  of  certificate  you  would  give  where 
you  found  the  accounts  properly  kept.  Also  where  accounts 
are  incorrect. 

(4)  (a)  Explain  how  you  would  proceed  in  auditing  th« 
affairs  of  a  corporation. 

(b)  In  an  audit  where  an  exhaustive  examination  of 
the  books  is  not  practicable,  what  are  the  particular  points 
to  which  the  attention  of  an  auditor  should  be  directed? 

(5)  State  briefly  your  duties  as  an  auditor  in  reference  to 
the  following  matters: 

(a)  Machinery  the  value  of  which  has  not  been  regu- 
larly depreciated. 

(b)  Loans  from  bankers. 

(c)  Doubtful  debts. 

(d)  Goodwill. 

(6)  How  would  you  as  auditor  of  an  incorporated  company 
satisfy  yourself  of  the  existence  of  shares  or  bonds  given  as 
security  for  loans  to  the  company? 

(7)  What  important  items  would  you  look  for  in  auditing 
accounts  of  a  county,  a  city  and  a  school  district? 


APPENDIX  E.  529 

(8)  A  firm  of  export  merchants  desires  a  thorough  investi- 
gation of  the  past  year's  transactions,  having  reason  to  suspect 
fraud.  State  concisely  upon  what  Hues  you  would  proceed  to 
satisfy  yourself  that: 

(a)  Goods  had  been  taken  out  of  the  store  on  bond  in 
the  way  shown  by  the  books. 

(b)  They  had  been  shipped  to  account  of  proper  con- 
signee. 

(c)  That  no  goods  had  been  removed  without  being 
charged. 

(d)  That  no  fictitious  entries  had  been  made  in  the 
books. 

MICHIGAN. 
Examination  held  June  26,  1908. 

( 1 )  What  is  an  auditor's  duty  with  regard  to  the  following 
items  appearing  upon  a  balance  sheet?  Imprest  cash,  notes 
receivable,  customers'  accounts,  sundry  debtors,  mortgages 
payable,  certificates  of  deposit,  patents,  goodwill,  preliminary 
(or  organization)  expenses,  stocks  and  bonds,  purchase  cred- 
itors' accounts  and  sundry  creditors. 

(2)  What  do  you  understand  by  the  term  "  secret  or  hidden 
reserves?"  Mention  four  (4)  bona  fide  uses  of  a  secret  re- 
serve and  state  your  opinion  as  to  the  propriety  or  otherwise 
of  the  creation  of  such  "  reserves,"  giving  reasons. 

(3)  The  J.  B.  &  B.  Coal  Mining  Company  has  acquired  a 
leasehold  right  to  a  certain  area  of  coal,  and  also  owns  free- 
hold coal.  What  would  you  require  as  auditor,  to  satisfy 
yourself  that  revenue  was  bearing  its  proper  annual  charge  in 
respect  of  the  coal  mined? 

(4)  Chart  the  following  accounts  of  a  street  railway  com- 
pany under  their  proper  classification  and  logical  order,  as  to 


530  AUDITING. 

assets  (active,  fixed,  and  passive),  liabilities  (funded,  floating^ 
reserves  and  capital),  expenses  (transportation,  including 
operating  of  power  plant  and  car  service),  general  (including 
administrative,  emergencies  and  fixed  charges),  maintenance,, 
(including  repairs  and  depreciation)  and  revenue  (a)  from 
operation  and  (b)  from  other  sources. 

Organization  expenses,  preliminary  engineering  and  superin- 
tendence, right  of  way,  track  and  roadway,  notes  payable,  cash 
in  office,  profit  and  loss,  power  plant  wages,  salaries  of  general 
officers,  damages,  taxes,  electric  line,  investment  real  estate,  de- 
bentures, vouchers  payable,  stocks  and  bonds  of  other  compa- 
nies, hired  power,  wages  of  conductors  and  motormen,  car  serv- 
ice supplies,  insurance,  first  mortgage  bonds,  Ninth  National 
Bank,  cleaning  and  sanding  tracks,  printing  and  stationery,, 
legal  expenses,  rent  of  land  and  buildings,  notes  receivable^ 
shop  tools  and  machinery,  passenger  receipts,  rolling  equip- 
ment, dividends,  material  and  supplies,  freight  receipts,  interest 
on  deposits,  track  rentals,  common  stock,  sinking  funds,  good- 
will, mail  receipts,  sale  of  power,  dividends  on  securities,  sal- 
aries of  clerks,  removal  of  snow  and  ice,  advertising  and  attrac- 
tions, storeroom  expenses,  steam  plant,  items  in  suspense,  im- 
pairment and  surplus,  first  preferred  stock,  repairs  to  equip- 
ment, reserves,  accounts  receivable,  second  preferred  stock, 
second  mortgage  bonds,  fuel  and  water  for  power  buildings, 
and  fixtures. 

(5)  A  $100.00  bond  is  issued  at  $115.00  and  is  payable  as  to 
$35.00  on  allotment  and  to  the  remaining  $80.00  in  four  equal 
instalments  at  intervals  of  two  months,  the  first  instalment 
being  due  two  months  after  the  allotment.  If  after  a  year  a 
dividend  of  $6.00  is  paid  on  each  bond,  what  is  the  average 
rate  of  interest  on  the  investment  for  the  whole  year? 

(6)  John  Adams,  a  capitalist,  contemplates  purchasing  the 
stock  of  the  American  Grain  Exporting  Company,  a  corpora- 
tion organized  with  a  capital  of  $200,000.00,  divided  into  1,000 
shares  preferred  stock  and  1,000  shares  common  stock,  par 


APPENDIX  E.  531 

value  $100.00  each,  six  per  cent.  (6%)  dividends,  payable  upon 
the  preferred  stock  before  any  dividends  are  declared  upon  the 
common  stock. 

This  stock  has  been  offered  to  Mr.  Adams  at  $60.00  per 
share  for  the  preferred,  and  $40.00  per  share  for  the  common. 

You  are  requested  to  audit  the  books  of  the  company  and 
give  your  opinion  as  to  the  value  of  the  stock.  You  find  the 
following  accounts  to  be  correct,  covering  a  period  of  one  year. 

Cash $900.00 

Accounts  receivable: 

Good $15,000.00 

Doubtful 4,000.00 

Bad 6,000.00        25,000.00 

Plant  and  machinery 75,000.00 

Horse  and  wagons 4,000.00 

Merchandise — Inventory 29,000.00 

GoodwiU 50,000.00 

Furniture  and  fixtures 2,000.00  , 

Expenses 3,000.00  ' ' 

Wages 15,000.00 

Purchases .     325,000.00 

Claims  and  rebates 8,000.00 

Ordinary  repairs 9,000.00 

Sales $260,400.00 

Mortgage  on  plant 25,000.00 

Accounts  payable 42,000.00 

Surplus 18,500.00 

Capital  stock 200,000.00 

Totals $545,900.00     $545,900.00 


Inventory  submitted  $129,000.00.  The  company  started 
business  six  years  ago  and  built  the  plant  and  machinery  and 
purchased  the  property  pertaining  to  fixed  capital.  Write  the 
report,  commenting  upon  the  advisability  of  the  purchase  and 
submit  profit  and  loss  statement  and  balance  sheet,  after  clos- 
ing books. 

(7)  The  cashier  of  a  firm  has  disappeared.  The  cash  book 
is  left  written  up  and  balanced  off,  the  custom  being  to  pay 
any  cash  balance  into  the  bank  each  day.     What  course  would 


532  AUDITING. 

you  take  to  ascertain  whether  there  were  any  defalcations,  if 
you  were  called  upon  to  audit? 

(8)  You  are  asked  by  a  client  how  to  treat  inventories  at 
the  time  of  closing  the  books,  e.  g.,  should  they  be  figured  at 
cost  or  market  price,  or  otherwise  ?  Is  the  common,  old-fash- 
ioned method  of  adding  the  inventory  of  merchandise  on  hand, 
to  the  credit  side  of  the  merchandise  account  before  closing 
the  books,  theoretically  correct?     Explain  fully. 

(9)  What  evidence  would  you  require  as  to  the  validity  of 
expenditure  in  respect  of  wages  paid  in  a  large  manufacturing 
plant,  and  as  to  the  value  of  the  inventories  of  stock  on  hand 
credited  to  loss  and  gain?  It  is  assumed  that  the  above  manu- 
facturing concern  kept  a  complete  cost  system,  which  was  an 
integral  part  of  the  general  books. 

(10)  The  market  value  of  the  investments  of  a  trust  com- 
pany has  fallen  considerably,  while  the  company  has  earned 
enough  income  to  pay  the  usual  dividend.  How  should  you 
deal  with  this  position  of  affairs  in  auditing  the  annual  ac- 
counts ? 

FLORIDA 

Examination  held  April  22,  1908. 

(i)  A  trading  company  discounts  some  of  its  bills  receiv- 
able. How  would  you  treat  such  transactions  in  the  books, 
and  how  would  you  show  such  discounted  bills  on  the  balance 
sheet  ? 

(2)  What  do  you  consider  the  proper  way  to  handle  cash 
in  accounts?  What  advantages  are  there,  if  any,  in  banking 
each  day  the  exact  receipts  of  the  previous  day? 

How  would  you  verify  the  correctness  of  a  cash  book,  and 
ensure  the  entry  of  all  cash  received? 

(3)  Define  "  periodical  audit "  and  "  continuous  audit." 
Give  two  or  three  reasons  for  and  against  each. 


APPENDIX  E.  533 

(4)  What  is  an  "  internal  check?  "  How  does  such  a  check 
affect  the  work  of  auditing  a  given  set  of  accounts? 

Give  at  least  one  example. 

(5)  What  are  the  objects  of  and  differences  between  an 
audit  and  an  examination? 

(6)  Give  in  detail  the  method  you  would  follow  in  auditing 
some  company  with  which  you  are  familiar. 

(7)  What  especial  duties  has  auditor  in  connection  with 
accounts  relating  to: — 

Patents  owned  by  a  corporation. 
Timber  rights  owned  by  a  corporation. 
Machinery  and  boilers  owned  by  a  corporation. 

(8)  Give  at  least  two  examples  of  contingent  liabilties,  and 
state  how  they  should  be  treated  in  the  books  and  on  the 
balance  sheet. 

(9)  A  company  is  organized  in  New  York  to  lend  money 
on  real  estate  mortgages  in  Florida. 

What  examination  should  an  auditor  make  of  such  mort- 
gages, and  how  would  he  guard  against  duplicate  mortgages 
on  the  same  property? 

(10)  A  new  company  sells  some  of  its  property  at  a  pre- 
mium. 

State  how  these  premiums  should  appear  in  the  accounts. 

(11)  Suppose  you  had  certified  the  balance  sheet  of  a  manu- 
facturing concern,  and  were  asked  by  a  stockholder  why  you 
had  certified  it  as  correct  when  some  of  the  assets  were  not 
salable  at  the  figures  placed  against  them,  what  reply  would 
you  make? 

(12)  What  duties  and  responsibilities  has  an  auditor  in  con- 
nection with  inventories  of  goods  on  hand  ? 


534  AUDITING. 

(13)  A  firm  has  been  doing  business  for  ten  years,  during 
which  time  no  audit  has  been  made  and  nothing  has  been 
charged  off  on  account  of  bad  debts.  There  are  six  hundred 
accounts  on  the  ledger. 

State  how  you  would  verify  and  classify  them. 

(14)  In  auditing  the  accounts  of  an  executor,  what  docu- 
ments would  you  require  ? 

What  is  the  necessity  of  keeping  real  estate  separate  from 
personal  property? 

(15)  Give  your  opinion  as  to  the  advantages,  or  disadvan- 
tages, of  bound  and  of  loose-leaf  ledgers ;  and  give  at  least  two 
methods  for  preventing  improper  abstracting  of  leaves  from 
loose-leaf  books. 

RHODE  ISLAND. 

Examination  held  December  26,  1907. 

(i)  What  is  your  understanding  of  a  cash  audit? 

(2)  What  measures  do  you  adopt  to  protect  yourself  against 
imposition  by  persons  who  have  access  to  the  books  while  you 
are  auditing  them? 

(3)  What  proofs  do  you  apply  to  insure  the  correctness  of 
an  audit? 

(4)  A  company  owns  all  the  capital  stock  of  another  com- 
pany. This  company  has  outstanding  an  issue  of  bonds  not 
guaranteed  by  the  company  holding  the  stock.  The  assets  of 
this  subsidiary  company  are  deemed  insufficient  to  cover  the 
bonds,  so  that  its  capital  stock  has  no  value.  The  owning  com- 
pany desires  the  auditor  to  prepare  its  balance  sheet,  setting  up 
the  assets  of  this  subsidiary  company  along  with  other  assets 
directly  owned  and  the  bonds  as  liabilities.  Is  it  proper  for 
him  to  do  so  under  the  circumstances  ?  Give  reasons  for  your 
answer. 


APPENDIX  E.  535 

(5)  What  do  you  consider  a  complete  checking  of  (a)  the 
/general  journal  (b)  the  purchase  journal? 

(6)  What  is  your  method  of  checking  dividends  paid? 

(7)  A  New  York  company  sells  its  capital  stock  at  a  pre- 
mium and  the  directors  pass  a  resolution  to  declare  a  dividend 
out  of  the  surplus  thus  paid  in.  Would  you  call  attention  to 
this  action  if  asked  to  make  up  the  accounts,  and  if  so,  why? 

(8)  In  examining  the  books  of  a  corporation  you  find  that 
an  officer  is  a  partner  in  a  business  from  which  the  corporation 
makes  purchases.  Upon  scrutiny  you  find  that  all  the  trans- 
actions are  at  proper  figures.  Would  you,  under  such  condi- 
tions, call  attention  to  the  fact  when  making  your  report  to  the 
directors  ? 

(9)  A  concern  owns  a  parcel  of  real  estate  which  cost  it 
$500,000.  There  is  a  purchase  money  mortgage  on  it  of 
$350,000.  You  are  asked  to  enter  the  same  in  the  balance 
sheet  of  $350,000  net.  Would  you  comply  with  thi?  request? 
Give  reasons  for  your  answer. 

(10)  A  person  is  interested  in  the  profits  of  a  corporation, 
but  is  not  a  shareholder  therein.  He  objects  to  having  the 
preliminary  expenses  enter  into  the  profit  and  loss  accounts. 
Is  his  position  tenable?     Give  reasons. 

(11)  A  manufacturing  concern  buys  raw  materials  in  ad- 
vance for  its  needs.  These  are  liable  to  fluctuations.  At  what 
prices  should  they  be  inventoried?     Why? 

(12)  Under  the  law  permitting  payment  of  dividends  solely 
out  of  surplus  earned,  a  corporation  pays  a  dividend  out  of 
general  surplus  after  carrying  its  losses  for  the  period  against 
the  account.  Would  you  make  mention  of  the  fact  in  the 
recital  accompanying  your  statements,  or  would  you  let  it  go 
without  specific  mention?     Give  reasons. 


536  AUDITING. 

(13)  Three  months  after  the  close  of  the  fiscal  year  you 
are  requested  to  audit  a  set  of  books  to  the  end  of  the  fiscal 
year.  How  do  you  ascertain  if  the  cash  called  for  by  the 
books  was  actually  on  hand  and  in  bank? 

(14)  A  teller  is  found  to  be  short  in  his  cash.  He  has 
been  in  the  position  for  a  period  of  three  years  and  has  a 
daily  record  of  cash  on  hand.  His  bond  of  suretyship  ante- 
dates the  discovery  of  the  shortage  by  a  period  of  six  months, 
and  it  contains  a  clause  that  the  surety  shall  not  be  liable  for  a 
shortage  existing  at  the  date  the  bond  became  effective.  You 
are  employed  by  the  surety  to  ascertain  if  the  shortage  falls 
within  the  period  of  the  bond.  What  steps  would  you  take? 
Do  you  think  that  you  would  be  successful  ? 

(15)  What  is  the  objection  to  loose-leaf  depositors'  ledgers? 


APPENDIX   F. 


The  following  extract  from  the  translation  of  Sir 
Walter  of  Henley's  "Tretyce  off  Housebandry" 
(a  manuscript  work  of  the  thirteenth  century) 
is  of  considerable  interest,  as  showing  the 
remarkable  similarity  of  the  duties  of  the 
Auditor  of  the  present  day  with  those  of  the 
Auditor  of  seven  hundred  years  ago: — 

"  Buy  and  sell  in  season  through  the  inspection  of  a  true 
man  or  two  who  can  witness  the  business,  for  often  it  happens 
that  those  who  render  accounts  increase  the  purchases  and 
diminish  the  sales.  Have  an  inspection  of  account,  or  cause 
it  to  be  made  by  some  one  in  whom  you  can  trust,  once  a  year, 
and  final  account  at  the  end  of  the  year.  View  of  Account 
is  made  to  know  the  state  of  things,  as  well  as  the  issues,  re- 
ceipts, sales,  purchases,  and  expenses,  and  for  raising  money. 
If  there  is  any  (money),  let  it  be  raised  and  taken  from  the 
hands  of  the  servants.  For  it  often  happens  that  servants  by 
themselves,  or  others,  make  merchandise  with  their  lord's 
money  to  their  own  profit;  and  if  arrears  appear  in  the  final 
account,  let  them  be  speedily  raised,  for  often  servants  are 
debtors  themselves,  and  make  others  debtors  whom  they  ought 
not — and  this  they  do  to  conceal  their  disloyalty.  Those  who 
have  the  goods  of  others  in  their  keeping  ought  to  keep  well 
four  things :  to  love  their  lord  and  respect  him ;  as  to  making 
profit,  they  ought  to  look  on  the  business  as  their  own;  as  to 
outlays,  they  ought  to  think  that  the  business  is  another's. 
But  there  are  few  servants  who  keep  these  four  things  alto- 
gether, as  many  take,  right  and  left,  where  they  judge  that 
their  disloyalty  Vv^ill  not  be  perceived.     Look  into  your  affairs 

537 


538  AUDITING. 

often,  and  cause  them  to  be  reviewed,  for  those  who  serve  you 
will  thereby  avoid  the  more  to  do  wrong,  and  will  take  pains 
to  do  better. 

"  In  the  first  place,  he  who  renders  account  ought  to  swear 
that  he  will  render  a  lawful  account,  and  faithfully  account 
for  what  he  has  received  of  the  goods  of  his  lord,  and  that 
he  will  put  nothing  in  his  roll  save  what  he  has  to  his  knowl- 
edge spent  lawfully,  and  to  his  lord's  profit.  And  the  clerk 
shall  swear  that  he  has  lawfully  entered  in  his  roll  what  he 
understands  his  master  has  received  of  the  lord's  goods,  and 
has  entered  nothing  in  the  roll  but  what  he  understands  may 
be  to  the  profit  of  the  lord.  And  then,  if  he  has  rendered  ac- 
count before,  see  how  it  compares;  and  if  he  is  found  in 
arrears  of  money,  corn,  or  stock,  put  the  whole  in  a  stated 
money  valuation,  and  charge  it  at  the  commencement  of  his 
roll,  also  charge  it  with  receipts  of  rents  and  many  other 
things. 

"  At  the  end  of  the  year,  when  all  the  accounts  shall  have 
been  rendered  of  the  lands,  the  issues,  and  all  expenses  of  the 
manor,  take  to  yourself  all  the  rolls,  and  by  one  or  two  of 
the  most  intimate  and  faithful  men  you  have,  make  very 
careful  comparison  with  the  rolls  of  the  accounts  rendered, 
and  of  the  rolls  of  the  estimate  of  corn  and  stock,  and  accord- 
ing as  they  agree  you  shall  see  the  industry  or  negligence  of 
your  servants'  and  bailiffs. 

"  The  lord  of  the  manor  ought  to  command  and  ordain  that 
the  accounts  be  heard  every  year,  not  in  one  place,  but  on  all 
the  manors,  for  so  can  one  quickly  know  everything,  and 
understand  the  profit  and  loss.  The  lord  ought  to  command 
the  Auditors  on  the  manors  to  hear  the  plaints  and  wrongs  of 
everybody  who  complains  of  the  steward  or  others,  that  full 
justice  be  done,  and  that  the  Auditors  do  right  at  their  peril. 

"  The  Auditors  ought  to  be  faithful  and  prudent,  knowing 
their  business,  and  all  the  points  and  articles  of  the  account 
in  rents,  outlays,  and  returns  of  stock.     And  the  accounts 


APPENDIX    F.  539 

ought  to  be  heard  at  each  manor,  to  know  the  profit  and  loss, 
and  then  can  the  Auditors  take  inquest  of  the  doings  which 
are  doubtful,  and  hear  the  plaints  of  each  plaintiff  and  make 
the  fines.  The  steward  ought  to  be  joined  with  the  Auditors, 
not  as  head  or  companion  of  the  account,  but  as  sub-ordinate, 
for  he  must  answer  to  the  Auditors  on  the  account  for  his 
doings,  just  as  another.  It  is  not  necessary  so  to  speak  to 
the  Auditors  about  making  audits,  for  they  ought  to  be  so 
prudent,  and  so  faithful,  and  so  knowing  in  their  business, 
that  they  have  no  need  of  others'  teaching  about  things  con- 
nected with  the  accounts." 


APPENDIX    G. 


CORPORATION   TAX   LAW. 

Text  of  the  law,  criticism  thereof  from  an  account- 
ing standpoint,  and  suggestions  for  making  the 
returns  required  from  corporations. 


With  the  exception  of  the  period  from  1817  to  1842,  Great 
Britain  has  taxed  incomes  for  over  a  century,  the  need  of 
funds  caused  by  the  Napoleonic  wars  being  the  occasion  of  the 
first  income  tax  law,  which  was  enacted  in  1798.  The  law  in 
force  at  the  present  time  was  passed  in  1853,  having  been  mod- 
ified in  some  particulars  by  amendments  at  different  times 
since. 

In  the  United  States  an  income  tax  was  proposed  in  1812 
as  a  means  of  raising  revenue  for  the  prosecution  of  the  war 
with  Great  Britain,  but  it  found  no  favor  with  Congress,  and 
the  act  was  never  passed.  In  1861,  however,  at  the  time  of 
the  Civil  War,  a  law  taxing  incomes  was  enacted,  such  taxation 
continuing  until  1872,  when  it  was  discontinued. 

In  1894  there  was  passed  by  Congress,  as  a  part  of  the 
Wilson  tariff  bill,  a  law  levying  a  tax  of  two  per  cent,  on 
incomes  in  excess  of  $4,000.  This  act  was  declared  unconsti- 
tutional by  the  Supreme  Court  as  being  in  conflict  with  clause 
4  of  Article  I,  Section  IX  of  the  Federal  constitution,  which 
reads : 

"  No  capitation  or  other  direct  tax  shall  be  laid,  unless  in 
proportion  to  the  census  or  enumeration  hereinbefore  directed 
to  be  taken." 

540 


APPENDIX  G.  541 

The  income  tax  levied  in  the  years  1862  to  1872  was  open  to 
the  same  constitutional  objection,  but  this  seems  to  be  one  of 
the  cases  in  which  the  Supreme  Court  reversed  itself,  the  older 
law  having  been  upheld  by  that  Court. 

The  act  passed  by  Congress  in  1909  as  a  part  of  the  Payne 
tariff  bill,  taxing  the  net  income  of  corporations,  is — any  legal 
fiction  to  the  contrary  notwithstanding — an  income  tax,  though 
in  this  instance  limited  to  the  "  net  income  "  of  corporations 
as  distinguished  from  all  incomes,  whether  of  corporations, 
partnerships  or  individuals.  This  is  quite  clearly  seen  when 
a  comparison  is  made  of  the  act  recently  passed  with  that  sec- 
tion of  the  act  of  28th  August,  1894,  pertaining  to  the  tax  on 
the  net  profits  or  income  of  corporations.  On  this  point  it  is 
interesting  to  note  the  opinion  of  one  of  the  leading  experts 
on  taxation  in  this  country — Lawson  Purdy,  President  of  the 
Department  of  Taxes  and  Assessment  of  New  York  City, 
who  is  quoted  as  saying :  "  From  whatever  point  of  view  the 
Federal  Corporation  Tax  is  studied,  it  is  unworkable  and  un- 
just; it  encroaches  upon  the  powers  of  the  States;  it  is  not 
productive  of  revenue ;  it  is  needlessly  inquisitorial ;  the  pub- 
licity required  is  rash  and  dangerous  in  the  extreme.  Its 
name  is  a  subterfuge.  It  is  an  income  tax,  and  not  an  excise 
tax.  It  has  the  vices  of  income  taxes,  without  the  merits 
of  an  income  tax  scientifically  framed." 

The  text  of  the  present  law,  being  Section  38  of  the  Payne 
tariff  bill,  approved  5th  August,  1909,  is  as  follows: 

Sec.  38.  That  every  corporation,  joint  stock  com-  *  Corporations 
pany  or  association,  organized  for  profit  and  having  Subject  to  Tax. 
a  capital  stock  represented  by  shares,  and  every  in- 
surance company  now  or  hereafter  organized  under 
the  laws  of  the  United  States  or  of  any  State  or 
Territory  of  the  United  States,  or  under  the  Acts 
of  Congress  applicable  to  Alaska  or  the  District 
of  Columbia,  or  now  or  hereafter  organized  under 
the  laws  of  any  foreign  country  and  engaged  in 
business  in  any  State  or  Territory  of  the  United 
States  or  in  Alaska  or  in  the  District  of  Columbia, 

♦The  marginal  notes  are  not  an  integral  part  of  the  law,  but  have  been  added  for 
the  convenience  of  the  reader. 


542 


AUDITING. 


J  Per  Cent,  of 
'*Net  Income" 
Over  $5,000. 


Foreign 
Corporations. 


Corporations 
Not  Subject  to 
Tax. 


How  ''Net  In- 
come"  Shall  Be 
Ascertained. 


shall  be  subject  to  pay  annually  a  special  excise 
tax  with  respect  to  the  carrying  on  or  doing  busi- 
ness by  such  corporation,  joint  stock  company  or 
association,  or  insurance  company,  equivalent  to 
one  per  centum  upon  the  entire  net  income  over  and 
above  five  thousand  dollars  received  by  it  from  all 
sources  during  such  year,  exclusive  of  amounts  re- 
ceived by  it  as  dividends  upon  stock  of  other  cor- 
porations, joint  stock  companies  or  associations,  or 
msurance  companies,  subject  to  the  tax  hereby  im- 
posed; or  if  organized  under  the  laws  of  any  for- 
eign country,  upon  the  amount  of  net  income  over 
and  above  five  thousand  dollars  received  by  it  from 
business  transacted  and  capital  invested  within  the 
United  States  and  its  Territories,  Alaska,  and  the 
District  of  Columbia  during  such  year,  exclusive  of 
amounts  so  received  by  it  as  dividends  upon  stock 
of  other  corporations,  joint  stock  companies  or  as- 
sociations, or  insurance  companies,  subject  to  the 
tax  hereby  imposed :  Provided,  however,  That  noth- 
ing in  this  section  C9ntained  shall  apply  to  labor, 
agricultural  or  horticultural  organization,  or  to 
fraternal  beneficiary  societies,  orders,  or  associa- 
tions operating  under  the  lodge  system,  and  provid- 
ing for  the  payment  of  life,  sick,  accident,  and' 
other  benefits  to  the  members  of  such  societies, 
orders,  or  associations,  and  dependents  of  such  mem- 
bers, nor  to  domestic  building  and  loan  associations, 
organized  and  operated  exclusively  for  the  mutual 
benefit  of  their  members,  nor  to  any  corporation  or 
association  organized  and  operated  exclusively  for 
religious,  charitable,  or  educational  purposes,  no* 
part  of  the  net  income  of  which  inures  to  the  benefit 
of  any  private  stockholder  or  individual. 

Second.  Such  net  income  shall  be  ascertained  by 
deducting  from  the  gross  amount  of  the  income  of 
such  corporation,  joint  stock  company  or  association, 
or  insurance  company,  received  within  the  year  from 
all  sources: 

ist.  All  the  ordinary  and  necessary  expenses  ac- 
tually paid  within  the  year  out  of  income  in  the 
maintenance  and  operation  of  its  business  and  prop- 
erties, including  all  charges^  such  as  rentals  or 
franchise  payments,  required  to  be  made  as  a  con- 
dition to  the  continued  use  or  possession  of  prop- 
erty. 

2nd.  All  losses  actually  sustained  within  the  year 
and  not  compensated  by  insurance  or  otherwise,  in- 
cluding a  reasonable  allowance  for  depreciation  of 
property,  if  any,  and  in  the  case  of  insurance  com- 
panies the  sums  other  than  dividends,  paid  within 
the  year  on  policy  and  annuity  contracts  and  the 
net  addition,  if  any,  required  by  law  to  be  made 
within  the  year  to  reserve  funds. 


APPENDIX   G. 


543 


3rd.  Interest  actually  paid  within  the  year  on  its 
bonded  or  other  indebtedness  to  an  amount  of  such 
bonded  and  other  indebtedness  not  exceeding  the 
paid-up  capital  stock  of  such  corporation,  joint  stock 
company  or  association,  or  insurance  company,  out- 
standing at  the  close  of  the  year,  and  in  the  case 
of  a  bank,  banking  association  or  trust  company, 
all  interest  actually  paid  by  it  within  the  year  on 
deposits. 

4th.  All  sums  paid  by  it  within  the  year  for  taxes 
imposed  under  the  authority  of  the  United  States  or 
of  any  State  or  Territory  thereof,  or  imposed  by 
the  government  of  any  foreign  country  as  a  condi- 
tion to  carrying  on  business  therein. 

5th.  All  amounts  received  by  it  within  the  year 
as  dividends  upon  stock  of  other  corporations,  joint 
stock  companies  or  associations,  or  insurance  com- 
panies, subject  to  the  tax  hereby  imposed: 

Provided,  That  in  the  case  of  a  corporation,  joint 
stock  company  or  association,  or  insurance  company, 
organized  under  the  laws  of  a  foreign  country,  such 
net  income  shall  be  ascertained  by  deducting  from 
the  gross  amount  of  its  income  received  within  the 
year  from  business  transacted  and  capital  invested 
within  the  United  States  and  any  of  its  Territories, 
Alaska,  and  the  District  of  Columbia: 

I  St.  All  the  ordinary  and  necessary  expenses  act- 
ually paid  within  the  year  out  of  earnings  in  the 
maintenance  and  operation  of  its  business  and  prop- 
erty within  the  United  States  and  its  Territories, 
Alaska,  and  the  District  of  Columbia,  including  all 
charges  such  as  rentals  or  franchise  payments  re- 
quired to  be  made  as  a  condition  to  the  continued 
use  or  possession  of  property. 

2nd.  All  losses  actually  sustained  within  the  year 
in  business  conducted  by  it  within  the  United 
States  or  its  Territories,  Alaska,  or  the  District  of 
Columbia  not  compensated  by  insurance  or  other- 
wise, including  a  reasonable  allowance  for  depre- 
ciation of  property,  if  any,  and  in  the  case  of  insur- 
ance companies  the  sums  other  than  dividends,  paid 
within  the  year  on  policy  and  annuity  contracts 
and  the  net  addition,  if  any,  required  by  law  to  be 
made  within  the  year  to  reserve  funds. 

3rd.  Interest  actually  paid  within  the  year  on  its 
bonded  or  other  indebtedness  to  an  amount  of  such 
bonded  ^  and  other  indebtedness,  not  exceeding  the 
proDortion  of  its  paid-up  capital  stock  outstanding 
at  the  close  of  the  year  which  the  gross  amount 
of  its  income  for  the  year  from  business  transacted 
and  capital  invested  within  the  United  States  and 
-iny  of  its  Territories,  Alaska,  and  the  District  of 
Columbia  bears  to  the  gross  amount  of  its  income 
derived  from  all  sources  within  and  without  the 
United  States. 


How  "Net 
Income"  of 

Foreign  Corpo- 
rations Shall  Be 
Ascertained. 


544 


AUDITING. 


Tax  to  Be 
Computed  on 
"  Net  Income  "  in 
Excess  of 
$5,000. 


Annual  Reports 
Required. 


What   Shall   Be 
Included  in 
Returns. 


4th.  The  sums  paid  by  it  within  the  year  for 
taxes  imposed  under  the  authority  of  the  United 
States  or  of  any  State  or  Territory  thereof. 

5th.  All  amounts  received  by  it  within  the  year 
as  dividends  upon  stock  of  other  corporations,  joint 
stock  companies  or  associations,  and  insurance  com- 
panies, subject  to  the  tax  hereby  imposed.  In  the 
case  of  assessment  insurance  companies,  the  actual 
deposit  of  sums  with  State  or  Territorial  officers, 
pursuant  to  law,  as  additions  to  guaranty  or  reserve 
funds  shall  be  treated  as  being  payments  required  by 
law  to  reserve  funds. 

Third.  There,  shall  be  deducted  from  the  amount 
of  the  net  income  of  each  of  such  corporations, 
joint  stock  companies  or  associations,  or  insurance 
companies,  ascertained  as  provided  in  the  forego- 
ing paragraphs  of  this  section,  the  sum  of  five  thou- 
sand dollars,  and  said  tax  shall  be  computed  upon 
the  remainder  of  said  net  income  of  such  corpora- 
tion, joint  stock  company  or  association,  or  insur- 
ance company,  for  the  year  ending  December  thirty- 
first,  nineteen  hundred  and  nine,  and  for  each  cal- 
endar year  thereafter ;  and  on  or  before  the  first  day 
of  March,  nineteen  hundred  and  ten,  and  the  first 
day  of  March  in  each  year  thereafter,  a  true  and 
accurate  return,  under  oath  or  affirmation  of  its 
president,  vice-president,  or  other  principal  officer, 
and  its  treasurer  or  assistant  treasurer,  shall  be 
made  by  each  of  the  corporations,  joint  stock  com- 
panies or  associations,  and  insurance  companies,  sub- 
ject to  the  tax  imposed  by  this  section,  to  the  col- 
lector of  internal  revenue  for  the  district  in  which 
such  corporation,  joint  stock  company  or  association, 
or  insurance  company,  has  its  principal  place  of 
business,  or,  in  the  case  of  a  corporation,  joint  stock 
company  or  association,  or  insurance  company,  or- 
ganized under  the  laws  of  a  foreign  country,  in  the 
place  where  its  principal  business  is  carried  on 
within  the  United  States,  in  such  form  as  the  Com- 
missioner of  Internal  Revenue,  with  the  approval  of 
the  Secretary  of  the  Treasury,  shall  prescribe,  set- 
ting forth : 

1st.  The  total  amount  of  the  paid-up  capital 
stock  of  such  corporation,  joint  stock  company,  or 
association,  or  insurance  company,  outstanding  at 
the   close  of  the  year. 

2nd.  The  total  amount  of  the  bonded  and  other 
indebtedness  of  such  corporation,  joint  stock  com- 
pany or  association,  or  insurance  company  at  the 
close  of  the  year. 

3rd.  The  gross  amount  of  the  income  of  such 
corporation,  joint  stock  company  or  association,  or 
insurance  company,  received  during  such  year  from 
all  sources,  and  if  organized  under  the  laws  of  a 


APPENDIX  G.  1  545 


foreign  country  the  gross  amount  of  its  income 
received  within  the  year  from  business  transacted 
and  capital  invested  within  the  United  States  and 
any  of  its  Territories,  Alaska,  and  the  District  of 
Columbia ;  also  the  amount  received  by  such  cor- 
poration, joint  stock  company  or  association,  or  in- 
surance company,  within  the  year  by  way  of  divi- 
dends upon  stock  of  other  corporations,  joint  stock 
companies  or  associations,  or  insurance  companies, 
subject  to  the  tax  imposed  by  this  section. 

4th.  The  total  amount  of  all  the  ordinary  and 
necessary  expenses  actually  paid  out  of  earnings  in 
the  maintenance  and  operation  of  the  business  and 
properties  of  such  corporation,  joint  stock  company 
or  association,  or  insurance  company,  within  the 
year,  stating  separately  all  charges  such  as  rentals 
or  franchise  payments  required  to  be  made  as  a 
condition  to  the  continued  use  or  possession  of  prop- 
erty, and  if  organized  under  the  laws  of  a  foreign 
country  the  amount  so  paid  in  the  maintenance  and 
operation  of  its  business  within  the  United  States 
and  its  Territories,  Alaska,  and  the  District  of 
Columbia. 

5th.  The  total  amount  of  all  losses  actually  sus- 
tained during  the  year  and  not  compensated  by  in- 
surance or  otherwise,  stating  separately  any  amounts 
allowed  for  depreciation  of  property,  and  in  the 
case  of  insurance  companies  the  sums  other  than 
dividends,  paid  within  the  year  on  policy  and  an- 
nuity contracts  and  the  net  addition,  if  any,  required 
by  law  to  be  made  within  the  year  to  reserve 
funds;  and  in  the  case  of  a  corporation,  joint  stock 
company  or  association,  or  insurance  company,  or- 
ganized under  the  laws  of  a  foreign  country,  all 
losses  actually  sustained  by  it  during  the  year  in 
business  conducted  by  it  within  the  United  States 
or  its  Territories,  Alaska,  and  the  District  of 
Columbia,  not  compensated  bj'  insurance  or  other- 
wise, stating  separately  any  amounts  allowed  for 
depreciation  of  property,  and  in  the  case  of  insur- 
ance companies  the  sums  other  than  dividends,  paid 
within  the  year  on  policy  and  annuity  contracts  and 
the  net  addition,  if  any,  required  by  law  to  be  made 
within  the  year  to  reserve  fund. 

6th.  The  amount  of  interest  actually  paid  within 
the  year  on  its  bonded  or  other  indebtedness  to  an 
amount  of  such  bonded  and  other  indebtedness  not 
exceeding  the  paid-up  capital  stock  of  such  corpora- 
tion, joint  stock  company  or  association,  or  insur- 
ance company,  outstanding  at  the  close  of  the  year, 
and  in  the  case  of  a  bank,  banking  association  or 
trust  company,  stating  separately  all  interest  paid 
by  it  within  the  year  on  deposits ;  or  in  case  of  a 
corporation,  joint  stock  company  or  association,  or 


546 


AUDITING. 


Incorrect 
Reports. 


Failure  to 
Report. 


Books  May  Be 
Examined. 


Aid  of  Courts 
May  Be  Invoked. 


insurance  company,  organized  under  the  laws  of  a 
foreign  country,  interest  so  paid  on  its  bonded  or 
other  indebtedness  to  an  amount  of  such  bonded 
and  other  indebtedness  not  exceeding  the  proportion 
of  its  paid-up  capital  stock  outstanding  at  the  close 
of  the  year,  which  the  gross  amount  of  its  income 
for  the  year  from  business  transacted  and  capital 
invested  within  the  United  States  and  any  of  its 
Territories,  Alaska,  and  the  District  of  Columbia, 
bears  to  the  gross  amount  of  its  income  derived  from 
all  sources  within  and  without  the  United  States. 

7th.  The  amount  paid  by  it  within  the  year  for 
taxes  imposed  under  the  authority  of  the  United 
States  or  any  State  or  Territory  thereof,  and  sep- 
arately the  amount  so  paid  by  it  for  taxes  imposed 
by  the  government  of  any  foreign  country  as  a  con- 
dition to  carrying  on  business  therein. 

8th.  The  net  income  of  such  corporation,  joint 
stock  company  or  association,  or  insurance  company, 
after  making  the  deductions  in  this  section  author- 
ized. All  such  returns  shall,  as  received,  be  trans- 
mitted forthwith  by  the  collector  to  the  Commis- 
sioner of  Internal  Revenue. 

Fourth.  Whenever  evidence  shall  be  produced 
before  the  Commissioner  of  Internal  Revenue  which, 
in  the  opinion  of  the  Commissioner,  justifies  the  be- 
lief that  the  return  made_  by  any  corporation,  joint 
stock  company  or  association,  or  insurance  company, 
is  incorrect,  or  whenever  any  collector  shall  report 
to  the  Commissioner  of  Internal  Revenue  that  any 
corporation,  joint  stock  company  or  association,  or 
insurance  company,  has  failed  to  make  a  return  as 
required  by  law,  the  Commissioner  of  Internal  Rev- 
enue may  require  from  the  corporation,  joint  stock 
company  or  association,  or  insurance  company  mak- 
ing such  return,  such  further  information  with  ref- 
erence to  its  capital,  income,  losses  and  expenditures 
as  he  may  deem  expedient ;  and  the  Commissioner  of 
Internal  Revenue,  for  the  purpose  of  ascertaining  the 
correctness  of  such  return  or  for  the  purpose  of 
making  a  return  where  none  has  been  made,  is  here- 
by authorized,  by  any  regularly  appointed  revenue 
agent  specially  designated  by  him  for  that  purpose, 
to  examine  any  books  and  papers  bearing  upon  the 
matters  required  to  be  included  in  the  return  of 
such  corporation,  joint  stock  company  or  associa- 
tion, or  insurance  company,  and  to  require  the  at- 
tendance of  any  officer  or  employee  of  such  cor- 
poration, joint  stock  company  or  association,  or  in- 
surance company,  and  to  take  his  testimony  with 
reference  to  the  matter  required  by  law  to  be 
included  in  such  return,  with  power  to  administer 
oaths  to  such  person  or  persons;  and  the  Commis- 
sioner  of   Internal   Revenue   may   also   invoke   the 


APPENDIX  G. 


547 


aid  of  any  court  of  the  United  States  having  juris- 
diction to  require  the  attendance  of  such  officers  or 
employees  and  the  production  of  such  books  and 
papers.  Upon  the  information  so  acquired  the  Com- 
missioner of  Internal  Revenue  may  amend  any  re- 
turn or  make  a  return  where  none  has  been  made. 
All  proceedings  taken  by  the  Commissioner  of  In- 
ternal Revenue  under  the  provisions  of  this  section 
shall  be  subject  to  the  approval  of  the  Secretary  of 
the  Treasury. 

Fifth.  All  returns  shall  be  retained  by  the  Com-  Additions  to 
missioner  of  Internal  Revenue,  who  shall  make  as-  Tax  for  False 
sessments  thereon;  and  in  case  of  any  return  made  q^.  ^q  Return. 
with  false  or  fraudulent  intent,  he  shall  add  one 
hundred  per  centum  of  such  tax,  and  in  case  of  a 
refusal  or  neglect  to  make  a  return  or  to  verify  the 
same  as  aforesaid  he  shall  add  fifty  per  centum  of 
such  tax.  In  case  of  neglect  occasioned  by  the  sick- 
ness or  absence  of  an  officer  of  such  corporation, 
joint  stock  company  or  association,  or  insurance 
company,  required  to  make  said  return,  or  for  other 
sufficient  reason,  the  collector  may  allow  such  fur- 
ther time  for  making  and  delivering  such  return  as 
he  may  deem  necessary,  not  exceeding  thirty  days. 
The  amount  so  added  to  the  tax  shall  be  collected  at 
the  same  time  and  in  the  same  manner  as  the  tax 
originally  assessed  unless  the  refusal,  neglect,  or 
falsity  is  discovered  after  the  date  for  payment  of 
said  taxes,  in  which  case  the  amount  so  added  shall 
be  paid  by  the  delinquent  corporation,  joint  stock 
company  or  association,  or  insurance  company,  im- 
mediately upon  notice  given  by  the  collector.  All 
assessments  shall  be  made,  and  the  several  corpora- 
tions, joint  stock  companies  or  associations,  or  insur- 
ance companies,  shall  be  notified  of  the  amount  for 
which  they  are  respectively  liable  on  or  before  the 
first  day  of  June  of  each  successive  year,  and  said 
assessments  shall  be  paid  on  or  before  the  thirtieth 
day  of  June,  except  in  cases  of  refusal  or  neglect  to 
make  such  return,  and  in  cases  of  false  or  fraudu- 
lent returns,  in  which  cases  the  Commissioner  of 
Internal  Revenue  shall,  upon  the  discovery  thereof, 
at  any  time  within  three  years  after  said  return  is 
due,  make  a  return  upon  information  obtained  as 
above  provided  for,  and  the  assessment  made  by 
the  Commissioner  of  Internal  Revenue  thereon  shall 
be  paid  by  such  corporation,  joint  stock  company 
or  association,  or  insurance  company  immediately 
upon  notification  of  the  amount  of  such  assessment ; 
and  to  any  sum  or  sums  due  and  unpaid  after  the 
thirtieth  day  of  June  in  any  year,  and  for  ten  days  Delinquent 
after  notice  and  demand  thereof  by  the  collector,  Taxes. 
there  shall  be  added  the  sum  of  five  per  centum  on 
the  amount  of  tax  unpaid  and  interest  at  the  rate 


548 


Reports 

Public 

Records. 


Information 
Not  to  Be 
Divulged. 


AUDITING. 


Penalty  for 
False  or  No 
Return. 


Internal 
Revenue  Laws 
Apply. 


United  States 
Circuit  and  Dis- 
trict Courts  Have 
Jurisdiction. 


of  one  per  centum  per  month  upon  said  tax  from 
the  time  the  same  becomes  due. 


Sixth.  When  the  assessment  shall  be  made,  as 
provided  in  this  section,  the  returns,  together  with 
any  corrections  thereof  which  may  have  been  made 
by  the  Commissioner,  shall  be  filed  in  the  office  of 
the  Commissioner  of  Internal  Revenue  and  shall 
constitute  public  records  and  be  open  to  inspection 
as  such. 

Seventh.  It  shall  be  unlawful  for  any  collector, 
deputy  collector,  agent,  clerk,  or  other  officer  or 
employee  of  the  United  States  to  divulge  or  make 
known  in  any  manner  whatever  not  provided  by 
law  to  any  person  any  information  obtamed  by  him 
in  the  discharge  of  his  official  duty,  or  to  divulge 
or  make  known  in  any  manner  not  provided  by  law 
any  document  received,  evidence  taken,  or  report 
made  under  this  section  except  upon  the  special  di- 
rection of  the  President ;  and  any  offense  against 
the  foregoing  provision  shall  be  a  misdemeanor  and 
be  punished  by  a  fine  not  exceeding  one  thousand 
dollars,  or  by  imprisonment  not  exceeding  one  year, 
or  both,  at  the  discretion  of  the  court. 

Eighth.  If  any  of  the  corporations,  joint  stock 
companies  or  associations,  or  insurance  companies, 
aforesaid,  shall  refuse  or  neglect  to  make  a  return 
at  the  time  or  times  hereinbefore  specified  in  each 
year,  or  shall  render  a  false  or  fraudulent  return, 
such  corporation,  joint  stock  company  or  associa- 
tion, or  insurance  company,  shall  be  liable  to  a  pen- 
alty of  not  less  than  one  thousand  dollars  and  not 
exceeding  ten  thousand  dollars. 

Any  person  authorized  by  law  to  make,  render, 
sign,  or  verify  any  return,  who  makes  any  false  or 
fraudulent  return,  or  statement,  with  intent  to  de- 
feat or  evade  the  assessment  required  by  this  section 
to  be  made,  shall  be  guilty  of  a  misdemeanor,  and 
shall  be  fined  not  exceeding  one  thousand  dollars  or 
be  imprisoned  not  exceeding  one  year,  or  both,  at 
the  discretion  of  the  court,  with  the  costs  of  prose- 
cution. 

All  laws  relating  to  the  collection,  remission,  and 
refund  of  internal  revenue  taxes,  so  far  as  applicable 
to  and  not  inconsistent  with  the  provisions  of  this 
section,  are  hereby  extended  and  made  applicable  to 
the  tax  imposed  by  this  section. 

Jurisdiction  is  hereby  conferred  upon  the  circuit 
and  district  courts  of  the  United  States  for  the  dis- 
trict within  which  any  person  summoned  under  this 
section  to  appear  to  testify  or  to  produce  books,  as 
aforesaid,  shall  reside,  to  compel  such  attendance, 
production  of  books,  and  testimony  by  appropriate 
process. 


APPENDIX  G.  549 


As  is  under  our  American  legislative  methods  so  fre- 
quently the  case,  those  best  qualified  to  advise  on  special  phases 
of  contemplated  legislation  are  not  consulted,  and  laws  are 
passed  which  impose  an  tmnecessary  burden  on  those  subject 
thereto.  An  apt  illustration  of  this  is  the  corporation  tax  act 
just  quoted. 

To  an  accountant  perusing  the  provisions  of  this  act,  it  is 
at  once  evident  that  no  member  of  the  profession  could  have 
been  consulted  when  the  law  was  framed.  Inasmuch  as  the 
determination  of  the  tax  to  be  paid  under  a  law  of  this  kind  is 
primarily  an  accounting  question,  the  omission  to  call  into  con- 
sultation those  most  competent  to  advise  as  to  the  simplest 
basis  on- which  to  determine  the  amount  of  tax  to  be  paid  by 
the  corporations  is  incomprehensible.  It  is  obvious  that  no 
consideration  at  all  was  paid  to  the  convenience  of  those  who 
must  pay  this  tax,  viz.,  the  corporations.  Even  if  the  law  is 
declared  to  be  unconstitutional,  no  decision  can  be  expected 
until  after  the  time  for  the  first  returns  has  passed. 

As  soon  as  the  text  of  the  proposed  law  was  published, 
however,  public  accountants  were  quick  to  perceive  the  gross 
errors  from  an  accounting  standpoint  contained  therein,  and  a 
copy  of  the  following  letter,  signed  by  twelve  prominent  firms 
of  New  York  City,  was  sent  to  each  member  of  Congress  and 
to  the  Attorney  General  of  the  United  States : 

New  York  City,  July  8th,  1909. 
Dear  Sir: 

On  reading  the  text  of  the  proposed  corporation  tax  law,  as  reported 
in  the  Commercial  and  Financial  Chronicle  of  July  3rd,  1909,  we  have 
formed  the  opinion  that  some  of  its  provisions  are  absolutely  impos- 
sible of  application,  and  others  violate  all  the  accepted  principles  of 
sound  accounting. 

Under  the  third  clause  it  is  provided  "that  there  shall  be  deducted 
from'  the  amount  of  the  net  income  of  each  of  such  corporations, 
.  .  .  ascertained  as  provided  in  the  foregoing  paragraphs  of  this 
section,  the  sum  of  $5,000.00,  and  said  tax  shall  be  computed  upon  the 
remainder   of   said  net   income   of   such   corporation    ...     for   the 


S50  AUDITING. 

year  ending  December  31st,  1909,  and  for  each  year  thereafter,  and  on 
or  before  the  ist  day  of  March,  1910,  and  the  ist  day  of  March  of  each 
year  thereafter,  a  true  and  accurate  return  under  oath  or  affirmation 
of  its  president,"  etc.,  etc. 

In  connection  with  this  clause  we  would  call  attention  to  the  fact 
that,  as  you  are  no  doubt  aware,  the  fiscal  year  of  a  number  of  corpo- 
rations is  not,  and  for  business  reasons  camiot  be,  the  calendar  year, 
and  consequently,  having  in  mind  that  in  such  cases  an  inventory  was 
not  taken  at  the  beginning  of  the  calendar  year  1909,  it  is  and  will  be 
quite  impossible  for  any  business,  corporation  or  institution,  whose 
fiscal  year  does  not  terminate  with  the  calendar  year,  to  make  a  true 
return  of  its  profits  as  required  by  the  proposed  law. 

Under  clause  i  the  tax  is  to  be  charged  upon  the  "  entire  net 
income,"  and  the  net  income  is  to  be  "ascertained  by  deducting  from 
the  gross  amount  of  the  income    .    .    .    from  all  sources," 

(i)  "Expenses  actually  paid," 

(2)  "Losses  actually  sustained," 

(3)  "  Interest  actually  paid," 

in  each  case  "within  the  year."  The  words  "actually  paid"  convey, 
and  it  is  to  be  presumed  are  intended  to  convey,  actual  disbursements 
out  of  the  treasury. 

The  proper  deductions  should  be: 

(i)  Expenses  actually  incurred  because  the  payment  is  not  neces- 
sarily made  in  the  year  in  which  the  expense  is  incurred; 

(2)  Losses  actually  ascertained  because  losses  may  be  incurred  and 
the  amount  not  be  ascertained  until  a  subsequent  period; 

(3)  Interest  actually  accrued  because  interest  is  never  paid  until 
the  end  of  the  period  during  which  it  accrues,  and  the  interest  accrued 
is  the  proper  charge  against  income. 

In  clause  l  the  bill  refers  to  "net  income  received";  in  clause  2  it 
refers  to  "  gross  income  "  without  the  addition  of  word  "  received " ; 
in  clause  3,  paragraph  3,  it  refers  to  "gross  income  received."  There 
is  here  a  complete  confusion  between  income  and  income  received, 
which  can  only  lead  to  endless  complication. 

Two  methods  may  be  adopted  for  taxation  purposes,  either 

(1)  To  tax  the  difference  between  actual  cash  receipts  on  revenue 
account  and  actual  cash  payments  on  revenue  account,  which  difference 
will  seldom  if  ever  represent  the  profits  of  a  manufacturing  concern ;  or 


APPENDIX  G.  55 1 

(2)  To  tax  profits  made  up  in  the  ordinary  commercial  way,  namely, 
to  ascertain  the  gross  income  earned,  whether  received  or  not,  and  to 
deduct  therefrom — 

1.  Expenses  actually  incurred  during  the  year,  whether  paid  or  not; 

2.  Losses  actually  ascertained  and  written  off  during  the  year  when- 
ever incurred; 

3.  Interest  accrued  during  the  year,  whether  paid  or  not; 

4.  A  reasonable  allowance  for  depreciation  of  property;  and 

5.  Taxes. 

As  accountants  actively  engaged  in  the  audit  and  examination  of  a 
number  of  varied  businesses  and  enterprises,  we  unhesitatingly  say  that 
the  law  as  framed  is  absolutely  impossible  of  application,  and  would 
suggest  that  in  the  said  clauses  i,  2  and  3  of  paragraph  2,  the  words 
"actually  paid"  and  "actually  sustained"  be  changed  to  read  "actu- 
ally incurred  "  and  "  actually  ascertained,"  and  that  the  third  clause  be 
changed  to  read  so  that  the  return  will  be  based  on  the  last  completed 
fiscal  year  prior  to  December  31st  in  cases  where  the  fiscal  year  of  a 
corporation  is  not  the  calendar  year. 
Yours  very  truly, 

Deloitte,  Plender,  Griffiths  &  Co.,  49  Wall  Street. 

Price,  Waterhouse  &  Co.,  54  William  Street 

Haskins  &  Sells,  30  Broad  Street. 

Lybrand,  Ross  Bros.  &  Montgomery,  165  Broadway. 

Wilkinson,  Reckitt  Williams  &  Co.,  52  Broadway. 

NiLES  &  NiLES,  III  Broadway. 

GuNN,  Richards  &  Co.,  43  Wall  Street. 

Edward  P.  Moxey  &  Co.,  165  Broadway. 

Geo.  H.  Church,  55  Wall  Street. 

Barrow,  Wade,  Guthrie  '&  Co.,  25  Broad  Street. 

LooMis,  CoNANT  &  Co.,  30  Broad  Street. 

Marwick,  Mitchell  &  Co.,  79  Wall  Street. 

To  this  letter  the  Attorney  General  replied  as  follows : 

Washington,  D.  C,  July  12th,  igog. 
Messrs.  Deloitte,  Plender,  Griffiths  &  Co., 

49  Wall  Street,  New  York. 
Gentlemen  : 

I  am  in  receipt  of  the  letter  signed  by  your  firm  and  a  number  of 
others  with  respect  to  the  proposed  corporation  tax  law,  in  which  you 
advise  me  that  you  have  formed  the  opinion  that  some  of  its  provisions 
are  absolutely  impossible  of  application  and  others  violate  all  the 
accepted  principles  of  sound  accounting. 


552  AUDITING. 

You  first  call  my  attention  to  the  fact  that  "the  fiscal  year  of  a 
number  of  corporations  is  not,  and  for  business  reasons  cannot  be,  the 
calendar  year,  and  consequently,  having,  in  mind  that  in  such  cases  an 
inventory  was  not  taken  at  the  beginning  of  the  calendar  year  1909,  it 
is  and  will  be  quite  impossible  for  any  business,  corporation  or  institu- 
tion, whose  fiscal  year  does  not  terminate  with  the  calendar  year,  to 
make  a  true  return  of  its  profits  as  required  by  the  proposed  law." 

I  beg  to  call  your  attention,  in  the  first  place,  to  the  fact  that  the 
proposed  law  does  not  impose  a  tax  upon  "  profits "  but  upon  "  the 
entire  net  income  over  and  above  five  thousand  dollars  received  by" 
the  corporation,  joint  stock  company  or  association,  or  insurance  com- 
pany subject  to  the  law,  from  "  all  sources  during  such  year."  It  has 
been  the  uniform  practice  of  the  Government  in  framing  revenue  bills 
to  require  the  tax  to  be  paid  as  of  a  fixed  date,  and,  so  far  as  I  have 
been  able  to  ascertain,  in  every  instance  the  tax  is  imposed  for  the  cal- 
endar year  ending  December  31st.  Such  was  the  income  tax  law  of 
1894.  It  may  be  inconvenient,  but  it  is  certainly  not  impossible  for  any 
corporation  which  keeps  just  and  true  books  of  account  to  make  up  a 
return  such  as  that  required  by  the  proposed  law,  particularly  as  the 
return  requires  statements  of  actual  receipts  and  payments,  and  not,  as 
you  recommend  in  your  communication,  of  expenses  "  incurred,"  inter- 
est "  accrued,"  and  losses  "  ascertained." 

2.  You  next  object  that  the  proposed  law  authorizes  the  deductions  of 
"  expenses  actually  paid,"  and  you  contend  that  this  should  be  changed 
to  read  "expenses*  actually  incurred."  The  bill  was  purposely  framed 
to  deal  with  receipts  and  disbursements  made  within  the  year  for 
which  the  tax  was  to  be  imposed,  and  the  words  "  actually  paid ''  were 
employed  advisedly.  The  same  may  be  said  with  respect  to  losses  ac- 
tually sustained  and  interest  actually  paid.  The  theory  of  the  framers 
of  the  bill  in  this  respect  differs  from  that  which  you  advocate. 

3.  You  then  object  that  in  Clause  i  the  bill  refers  to  "net  income 
received";  in  Clause  2  it  refers  to  "gross  income"  without  the  addi- 
tion of  the  word  "  received" ;  and  in  Clause  3,  Paragraph  3,  it  refers  to 
"gross  income  received,"  and  you  comment:  "There  is  here  a  com- 
plete confusion  between  income  and  income  received,  which  can  only 
lead  to  endless  complication." 

I  cannot  agree  that  there  is  any  confusion  whatever  in  this  respect. 
"  Gross  income  "  in  Clause  2  obviously  and  necessarily  means  "  gross 
income  received."  The  tax  is  imposed  by  Clause  i  upon  the  entire  net 
income  above  five  thousand  dollars  received  from  all  sources  during 
the  year.  By  Clause  2  "  such  net  income "  is  to  be  ascertained  by 
deducting  from  the  gross  amount  of  the  income  from  all  sources  the 
specified  items;  and   if  anybody  could  question  whether  that  meant 


APPENDIX  G.  553 

"  gross  income  received,"  his  doubt  would  be  removed  by  the  provisions 
in  Paragraph  3  of  Cause  31 

Your  further  statement  that  "  as  accountants  actively  engaged  in  the 
audit  and  examination  of  a  number  of  varied  businesses  and  enter- 
prises, we  imhesitatingly  say  that  the  law  as  framed  is  absolutely 
impossible  of  application,"  causes  me  very  great  surprise.  My  personal 
acquaintance  with  you  and  a  number  of  the  other  signers  of  the  letter 
leads  me  to  the  belief  that  you  have  underestimated  your  capacity. 
Certainly  the  statement  of  objections  made  in  your  letter  is  entirely 
insufficient  to  support  the  conclusion  which  you  express. 
I  am,  respectfully  yours, 

(Signed)     Geo.  W.  Wickersham, 

Attorney-General. 

On  receipt  of  this  letter  the  following  reply  was  written, 
giving  in  somewhat  more  detail  the  reasons  for  stating  that  the 
law  as  framed  was  practically  impossible  of  application : 

New  York,  July  21st,  1909. 
Hon.  Geo.  W.  Wickersham, 

Attorney-General  of  the  United  States, 
Washington,  D.  C 
Dear  Sir: 

We  have  to  acknowledge  receipt  of  your  letter  of  July  12th,  replying 
to  ours  of  July  8th. 

Our  only  object  in  addressing  you  was  to  be  of  assistance  in  a 
matter  of  practical  accounting  which  enters  into  the  proposed  law,  as 
to  which  we  believe  that  our  experience  specially  qualifies  us  to  speak. 
We  have  purposely  refrained  from  any  reference  to  the  policy  involved 
in  the  law,  with  which  we  as  Accountants  are  not  concerned. 

The  views  expressed  in  your  letter  of  the  12th  instant  would  seem 
to  indicate  that  you  have  not  fully  appreciated  the  difficulties  which 
will  be  met  with  in  carrying  into  effect  the  provisions  of  the  proposed 
law  as  amplified  and  explained  in  your  letter;  and  we  therefore  feel 
that,  in  justice  to  ourselves,  we  must  refer  at  greater  length  to  some 
matters  which  were  only  briefly  touched  upon  in  our  letter  of  July  8th. 

We  are  glad  to  have  your  clear  expression  as  to  the  intention  of  the 
law  to  deal  with  Receipts  and  Disbursements  only  (presumably  on 
Income  Account)  and  not  with  Income  Earned  (or  Profits)  and 
Expenditures  incurred.  Under  these  circumstances  it  would  seem  better 
to  use  the  term  "  Receipts  on  Income  Account "  and  "  Disbursements 
on  Income  Account"  rather  than  "Income"  and  "Expense,"  as  the 
latter  terms  are  more  commonly  defined  and  used  in  relation  to  Income 


554  AUDITING. 

earned  and  Expenses  incurred.  In  any  case,  if  in  Clause  2  "Gross 
Income"  means,  as  you  state  it  is  intended  to  mean,  "Gross  Income 
received,"  it  would  certainly  be  better  to  say  so  and  thus  remove  any 
possible  ambiguity. 

We  note  that  you  refer  to  the  precedent  of  the  Income  Tax  Law  of 
1894.  We  believe  that  this  law  was  declared  unconstitutional  before 
there  had  been  time  to  experience  the  difficulties  and  uncertainties 
which  any  attempt  to  enforce  it,  if  drawn  on  the  lines  of  the  present 
bill,  would  have  involved.  In  this  connection  we  may  perhaps  point 
to  the  precedent  of  the  English  Income  Tax  Law  which  has  stood  the 
test  of  over  half  a  century.  In  this  case  the  tax  is  on  Profits,  which  in 
this  country  are  frequently  termed  "Net  Income";  and  the  accounts 
of  corporations  prepared  in  the  regular  course  of  business  for  their 
respective  fiscal  years  are  and  always  have  been  accepted  as  the  basis 
of  taxation,  subject  to  minor  provisions  as  to  rates  of  depreciation, 
interest  deductions,  etc. 

Our  main  criticism  of  the  bill  in  its  present  form  is  that  in  the  large 
majority  of  cases  it  will  be  impossible  of  application  for  the  year  1909, 
as  explained  in  our  previous  letter,  and  very  difficult  and  expensive,  if 
not  altogether  impossible,  in  subsequent  years. 

Railroads  perhaps  require  the  simplest  form  of  accounting  obtaining 
among  business  corporations.  These  accounts  are  kept  in  a  form  pre- 
scribed by  the  Interstate  Commerce  Commission,  and  severe  penalties 
can  be  inflicted  for  any  departure  from  those  forms.  They  must  be 
kept  on  a  basis  not  of  Receipts  and  Disbursements,  but  of  Earnings, 
whether  collected  in  cash  or  not,  and  of  Expenses,  whether  paid  or 
not,  which  in  both  cases  accrued  during  the  fiscal  year  closing  on  June 
30th,  the  outstanding  Income  and  Expense  items  uncollected  and 
unpaid  running  into  very  large  figures  and  frequently  varying  con- 
siderably in  amount  between  one  year  and  another.  While  it  would  be 
possible  to  prepare  also  an  account  of  Receipts  and  Disbursements,  this 
would  involve  a  great  deal  of  extra  work  in  the  compilation  of  special 
data  and  would  raise  most  difficult  questions  as  to  the  proper  distribu- 
tion between  Capital  and  Income  of  large  payments  for  stores,  the 
ultimate  use  of  which  is  not  and  cannot  be  known  at  the  time  of  pay- 
ment. 

Turning  now  from  this,  which  is  perhaps  the  most  simple  case,  to 
that  of  a  large  manufacturing  concern  producing  all  kinds  of  finished 
products  out  of  purchases  of  ore  and  other  raw  materials,  an  accurate 
or  even  approximate  statement  of  cash  Receipts  and  Disbursements  on 
Income  Account  is  a  practical  impossibility  at  any  time.  Cash  Re- 
ceipts arising  from  sales  of  products  can  be  ascertained  without  much 
difficulty  beyond  requiring  considerable  extra  work.     But  no  system 


APPENDIX  G  555 

of  accounting  can  give  even  approximately  "  the  ordinary  and  necessary 
expenses  actually  paid  within  the  year  out  of  Income  in  the  main- 
tenance and  operation  of  its  business  and  properties."  Such  expenses 
presumably  must  include  the  cost  of  the  goods  sold.  Into  this  cost, 
and  following  it  through  all  the  intricate  accounting  which  has  been 
found  to  be  necessary,  are  raw  materials  actually  used  in  manufacture, 
labor  expended  and  innumerable  items  of  expense  which  are  taken  into 
costs  as  they  accrue,  quite  irrespective  of  the  date  of  payment.  Very 
large  inventories  are  carried  of  materials  and  supplies  which  are  pur- 
chased at  one  period,  paid  for  at  another,  and  used  at  all  sorts  of  times 
in  all  sorts  of  quantities,  and  for  all  sorts  of  purposes,  mainly  for 
manufacture  into  products  for  sale,  but  to  a  large  extent  for  additions 
to  or  extensions  of  the  plant.  Such  as  are  user  for  the  latter  purpose 
are  not,  as  we  understand  the  proposed  law,  a  proper  deduction  from 
Gross  Income,  and  yet  long  before  they  are  used  all  identity  between 
the  materials  themselves  and  the  disbursements  made  for  them  has  been 
lost.  There  is,  in  our  opinion,  no  method  in  which  any  such  statement 
as  that  called  for  in  the  proposed  law  can  be  prepared  short  of  an 
entirely  independent  and  separate  set  of  books,  designed  to  follow  each 
bill  paid  through  to  the  ultimate  destination  of  the  materials  or  services 
covered  thereby,  thus  duplicating  the  present  cost  of  the  Accounting 
Department  and  serving  no  useful  purpose  whatever.  Even  if  such 
method  were  adopted  it  is  very  doubtful  if  it  would  produce  the  results 
required  with  even  approximate  accuracy. 

Without  unduly  burdening  this  letter,  it  is  impossible  to  go  into  fur- 
ther details  here ;  but  the  facts  must,  in  the  opinion  of  any  one  familiar 
with  the  operations  and  accounts  of  a  compHcated  modern  manufactur- 
ing concern,  fully  justify  the  conclusions  which  we  expressed  in  our 
letter  of  July  8th,  and  which  we  now  emphatically  endorse.  Whether 
the  proposed  method  is  physically  impossible,  or  merely,  as  you  state, 
"inconvenient,"  it  will,  we  think,  be  generally  conceded  that  it  is  in 
the  general  interest  of  the  effective  administration  of  laws  relating  to 
taxes  that  they  should  involve  as  little  inconvenience  as  possible  upon 
those  required  to  make  returns  thereunder.  The  basis  for  arriving  at 
the  amount  liable  to  taxation  suggested  in  our  former  letter  would  have 
the  advantage  of  simplicity,  and  if  the  tax  is  to  be  a  permanent  institu- 
tion, its  efficient  operation  would  be  greatly  facilitated  by  conformity 
with  regular  accounting  methods. 

We  have  felt  it  our  duty  to  protest  strongly  against  the  wording  of 
the  proposed  bill  upon  the  grounds  set  forth,  but  our  object  is  to  help 
and  not  to  hinder.  If  you  think  any  good  purpose  would  be  served  by 
our  appearing  before  you  and  discussing  this  matter  fully  with  a  view 
to  arriving  at  a  satisfactory  solution,  which  we  are  satisfied  can  be 


55^  AUDITING. 

done,  we  shall  be  pleased  to  hold  ourselves  at  your  disposal  for  this 
purpose. 

Regretting  our  inability  to  in  any  way  modify  the  conclusions  already 
expressed,  We  are.  Dear  Sir, 

Yours  very  truly, 
Deloitte,  Plender,  Griffiths  &  Co.,  49  Wall  Street. 
Price,  Waterhouse  &  Co.,  54  William   Street 
Haskins  &  Sells,  30  Broad  Street. 
LyBRAND,  Ross  Bros.  &  Montgomery,  165  Broadway. 
Marwick,  Mitchell  &  Co.,  79  Wall  Street. 
NiLEs  &  NiLES,  III  Broadway. 
GuNN,  Richards  &  Co.,  43  Wall  Street. 
Edward  P.  Moxey  &  Co.,  165  Broadway. 
Barrow,  Wade,  Guthrie  &  Co.,  25  Broad  Street. 
LooMis,  CoNANT  &  Co.,  30  Broad  Street. 
SuFFERN  &  Son,  165  Broadway. 

The  following  letter  from  the  Attorney  General  closed  the 
correspondence : 

Washington,  D.  C,  July  22,  1909. 
Messrs.  Deloitte,  Plender,  Griffiths  &  Co., 
49  Wall  Street, 
New  York. 
Dear  Sirs: — 

I  have  a  letter  dated  the  21st  instant,  signed  by  yourself  and  a  num- 
ber of  other  firms  of  accountants,  in  response  to  my  letter  of  July  12th, 
replying  to  your  former  letter  of  July  8th.  In  your  last  letter  you  set 
forth  in  somewhat  more  detail  the  following  proposition : 

"  But  no  system  of  accounting  can  give  even  approximately  *  the  ordi- 
nary and  necessary  expenses  actually  paid  within  the  year  out  of  income 
in  the  maintenance  and  operation  of  its  business  and  properties.' " 

I  think  the  bare  statement  of  that  proposition  would  be  received  with 
very  great  incredulity  by  most  minds.     Certainly,   I  am  quite  unable 
to  assent  to  it.     However,  it  is  now  too  late  to  attempt  to  recast  the 
corporation  tax  amendment  bill  on  the  basis  of  such  proposition. 
Respectfully  yours, 

(Signed)     Geo.  W.  Wickersham, 

Attorney-General. 

It  is  unfortunate  that  the  scientific  income  earned  and  ex- 
pense incurred  basis  of  determining  the  net  income  subject  to 
taxation  should  have  been  abandoned  for  the  crude  and — as 


APPENDIX  G.  557 

pointed  out  in  the  accountants'  letter — unsatisfactory,  if  not  im- 
possible, cash  receipts  and  payments  basis,  which  the  Attorney- 
General  states  is  contemplated  by  the  law.  Particularly  strange 
is  this,  as  the  framers  of  the  present  law  had  the  Act  of  1894 
to  guide  them.  That  act  unquestionably  contemplated  a  true 
income  and  expense  basis  of  determining  the  net  profits  or 
income,  as  it  stated  inter  alia: 

"  The  net  profits  or  income  of  all  corporations,  companies  or 
associations  shall  include  the  amounts  paid  to  shareholders,  or 
carried  to  the  account  of  any  fund,  or  used  for  construction, 
enlargement  of  plant,  or  any  expenditure  or  investment  paid 
from  the  net  annual  profits  made  or  acquired  by  said  corpora- 
tions, companies  or  associations." 

An  examination  of  the  forms  required  under  that  act  by  the 
Commissioner  of  Internal  Revenue  further  substantiates  this 
view.  The  wording  of  the  following  items  in  the  form  of 
return  are  in  point: 

"  I.  Gross  receipts,  credits,  earnings  and  gains  from  any 
business.     ... 

"  2.  From  interest  or  coupons,  due  or  paid  on  any 
bonds.     .     .     . 

"  4.  From  undivided  profits  of  any  corporation,  company  or 
association. 

"  8.  From  interest  received  or  accrued  on  all  notes,  bonds, 
mortgages,  or  other  forms  of  indebtedness  not  included  in  the 
foregoing  items. 

"  10,  From  rents  received  or  accrued." 

The  following  items  among  the  "  Operating  and  Business 
Expenses  "  likewise  show  the  intention  to  have  the  net  income 
ascertained  on  a  scientific  basis : 

"  I.  Interest  paid  or  accrued  within  the  year  on  bonded  or 
other  indebtedness. 


55^  AUDITING. 

"  7.  Cost  price  of  material  purchased  for  manufacture  or 
resale,  not  increasing  stock  on  hand  (at  beginning  of  year)." 

It  is  true  that  that  act,  or  the  interpretation  of  it,  was  also 
open  to  some  criticisms  from  an  accounting  standpoint,  but  not 
to  the  same  extent  as  the  present  law  which,  instead  of  being 
an  improvement  on  the  previous  act,  is  the  reverse. 

Aside  from  the  direct  accounting  principles  involved,  one 
of  the  most  serious  objections  to  the  basis  prescribed  by  the 
law  for  making  returns  thereunder  is  that  the  returns  made  will 
be  quite  independent  of  and  not  at  all  in  agreement  with  the 
books  of  account  of  the  corporations  making  the  returns.  Of 
course,  if  any  corporation  should  keep  its  books  on  a  purely 
cash  basis  without  attempting  to  determine  its  actual  profit, 
then  its  books  would,  or,  rather,  should,  be  in  agreement  with 
the  government  returns.  It  is  doubtful,  however,  whether  the 
accounting  officers  of  such  a  corporation  (if  such  a  one  exists) 
would  know  enough  to  fill  out  the  simplest  kind  of  blanks  so 
that  the  government  officials  would  probably  find  quite  as  much 
trouble  in  verifying  its  returns  as  may  be  expected  in  the  case 
of  the  ordinary  corporation.  Hence  it  will  not  be  possible  for 
the  Internal  Revenue  Commissioner  or  his  agents  to  verify  the 
returns  without  exhaustive  examination  of  all  the  details  on 
which  they  are  based.  Even  in  the  case  of  wilful  misstate- 
ments it  will  be  extremely  difficult,  if  not  in  many  instances 
impossible,  to  prove  fraudulent  intent,  as  the  excuse  of  clerical 
error  or  mistaken  opinion  can  be  pleaded  to  the  limit,  there 
being  no  permanent  records  of  the  corporation  to  which  the 
returns  must  conform,  as  there  would  be  if  the  returns  were 
required  on  the  same  basis  on  which  the  accounts  of  corpora- 
tions are  ordinarily  kept. 

Government  control  is  being  pushed  rather  far,  but  one  can- 
not even  consider  the  possibility  of  corporations  being  required 
to  keep  two  sets  of  books — one  to  meet  the  actual  necessities 
of  business  conditions  and  the  other  to  satisfy  the  possible 
curiosity  of  an  Internal  Revenue  Collector.     Followed  out  to 


APPENDIX  G.  559 

its  logical  conclusion,  the  collector  would  have  to  compare  the 
two  sets  of  books  so  that  in  time  there  would  be  several  hun- 
dred thousand  inspectors. 

At  the  time  of  signing  the  tariff  bill  the  President  made  the 
following  statement : 

"  The  corporation  tax  is  a  just  and  equitable  excise  measure, 
which,  it  is  hoped,  will  produce  a  sufficient  amount  to  prevent 
a  deficit,  and  which,  incidentally,  will  secure  valuable  statistics 
and  information  concerning  the  many  corporations  of  the  coun- 
try and  will  constitute  an  important  step  toward  that  degree 
of  publicity  and  regulation  which  the  tendency  in  corporate 
enterprises  in  the  last  twenty  years  has  shown  to  be  necessary." 

Subsequently,  in  a  speech  made  at  Denver,  he  stated : 

"Another  feature  of  it  (the  corporation  tax  law)  is  that, 
incidentally,  it  will  give  the  Federal  Government  an  opportunity 
to  secure  most  valuable  information  in  respect  to  the  conduct 
of  corporations,  their  actual  financial  condition,  which  they  are 
required  to  show  in  general  terms  in  a  public  return." 

And  he  is  also  quoted  as  saying,  "  It  is  .  .  .  in  effect 
an  income  tax — that  is,  it  taxes  earnings  actually  made." 

From  the  letters  quoted,  it  is  quite  clear  that  the  returns  will 
have  little  statistical  or  informative  value,  as  they  will  not  show 
the  true  net  income  of  the  corporations  for  any  fiscal  period, 
nor  will  there  be  any  showing  of  the  "  actual  financial  condi- 
tion "  of  the  corporations,  as  the  only  return  of  that  kind  called 
for  by  the  law  is  a  statement  of  the  paid-up  capital  stock  and 
bonded  and  other  indebtedness,  no  mention  whatever  being 
made  of  assets  or  surplus. 

If  the  government  is  really  seeking  to  secure  greater  or 
more  effective  control  of  corporations — and  the  President  says 
this  is  the  case — an  excellent  opportunity  to  exercise  indirectly 
effective  control  of  the  accounts  of  corporations  is  being 
neglected.    The  powers  to  prescribe  the  form  in  which  the  ac- 


560  AUDITING. 

counts  of  interstate  common  carriers  shall  be  kept,  to  compel 
the  submission  of  reports  prepared  therefrom,  and  to  inspect  at 
its  pleasure  the  records  kept  by  carriers,  are  rightly  considered 
as  among  the  most  comprehensive  powers  enjoyed  by  the  Inter- 
state Commerce  Commission.  While  the  submission  of  reports 
prepared  on  a  true  income  and  expense  basis  and  for  the  cor- 
poration's fiscal  year  would  not  have  given  the  government  the 
same  control  of  the  accounting  of  other  corporations  as  it  has 
of  common  carriers,  it  would  have  resulted  in  an  annual  return 
which  would  show  the  real  operations  of  the  corporation  and 
one  which  could  be  readily  verified  by  reference  to  the  corpora- 
tion's books  of  account.  Still  more  important  would  be  the 
indirect  control  acquired  of  the  course  to  be  followed  with 
regard  to  such  questions  as  those  of  depreciation  of  property 
and  losses  sustained.  By  providing  that  only  such  depreciation 
and  losses  as  were  actually  written  off  on  the  books  would  be 
allowed  as  deductions  from  gross  income,  it  would  be  to  the 
interest  of  directors  to  face  the  facts  and  take  cognizance  of 
them  in  the  corporation's  records  instead  of  ignoring  them  to 
the  ultimate  detriment  of  the  stockholders'  interests,  as  has 
happened  in  more  than  one  instance  in  the  past.  By  fixing,  on 
the  other  hand,  maximums  of  depreciation  which  would  be 
allowed  as  deductions  in  any  one  year,  the  possible  tendency  to 
write  off  excessive  amounts  for  depreciation  of  property,  thus 
reducing  the  net  income  on  which  the  tax  would  be  payable 
and  incidentally  creating  large  secret  reserves,  would  be  cor- 
rected. 

Coming  finally  to  the  question  of  how  to  make  the  returns 
required  by  the  law,  it  may  as  well  be  frankly  admitted  that, 
as  pointed  out  in  the  letters  of  the  accountants,  it  will,  in  the 
case  of  many  corporations,  be  impossible  to  comply  literally 
with  the  requirements  of  the  act  and  that  the  returns  must, 
therefore,  necessarily  be  only  an  approximation. 

In  view  of  the  proposed  testing  of  the  constitutionality  of  the 
law,  it  is  suggested  that  all  statements,  reports  and  payments 
(if  any)  be  made  under  protest. 


APPENDIX  G.  561 

Insurance  Companies;  In  the  case  of  banks  and  insurance 
companies,  aside  from  the  unnecessary  additional  labor 
involved,  there  will  be  little  or  no  difficulty  in  making  a  return 
which  will  be  in  precise  compliance  with  the  law  as  interpreted 
in  the  Attorney-Generars  letter.  In  fact,  insurance  companies, 
whose  accounting  systems  are  quite  crude  as  compared  with 
those  of  railroads  and  industrial  corporations,  can  base  their 
returns  on  the  so-called  "  Income  and  Disbursements  "  state- 
ment required  by  the  State  Insurance  Departments.  The  fol- 
lowing modifications  will,  however,  be  necessary: 

Elimination  from  the  "  disbursements " — which 
become  "  deductions  "  from  the  gross  income  under 
the  wording  of  the  act — dividends  paid  to  or  allowed 
to  policy-holders  (including  the  "  dividends  "  of  mu- 
tual fire  insurance  companies),  and  in  the  case  of 
stock  companies  dividends  paid  to  stockholders. 

Add  to  the  disbursements  for  the  purpose  of  ob- 
taining the  total  deductions  from  the  gross  receipts 
which  will  be  allowed — 


Additions  to  the  Insurance  Reserve  * 


Dividends  received  upon  stocks  of  corporations  sub- 
ject to  the  corporation  tax. 

No  specific  provision  is  made  for  the  deduction  of  the  amor- 
tized premium  on  bonds,  though  it  might  be  construed  as 
coming  within  the  scope  of  "  all  losses  actually  sustained  within 
the  year."  In  one  sense  it  may  be  argued  that  it  is  a  loss,  vis., 
that  the  premium  is  by  the  effluxion  of  time  disappearing.  The 
fact  is  that  it  is  being  gradually  repaid  to  the  investor — ^in 
this  case  the  insurance  companies — and  thus  the  true  net 
income  is  not  shown  until  there  is  deducted  from  the  gross 
amount  of  interest  received  on  bonds  that  portion  which  repre- 


*To  judge  from  the  wording  of  the  act,  ''required  by  law,"  the  amount  of  reserves 
made  in  excess  of  the  standard  required  by  the  State  Insurance  Departments  will  not 
be  allowed  as  a  deduction. 


^^2  AUDITING. 

sents  the  partial  return  of  principal,  or  the  premium  written  off 
during  the  year  on  an  amortization  basis. 

Banks  and  Trust  Companies:  In  the  case  of  banks  and  trust 
companies,  from  the  gross  amount  of  receipts  from  interest, 
discount  and  other  sources,  there  will  be  deductible  expenses 
and  taxes  paid,  interest  on  deposits  (presumably  interest  cred- 
ited to  depositors*  accounts  will  be  considered  as  "  actually 
paid  "),  losses  due  to  uncollectible  loans  and  the  like,  an  allow- 
ance for  depreciation  of  banking  house  and  fixtures  and  divi- 
dends received  on  corporation  stocks  owned.  If  real  estate, 
other  than  the  banking  house,  be  owned,  it  would  also  be 
proper  to  claim  deduction  for  depreciation  of  any  buildings,  as 
well  as  of  any  ground,  which  had  depreciated  in  value. 

Mercantile  Corporations,  whose  operations  are  confined 
strictly  to  trading,  will  find  comparatively  few  difficulties  in 
preparing  the  returns  required.  The  figures  will  naturally  be 
worked  up  from  the  cash-book,  all  receipts  being  carefully 
scrutinized  so  as  to  eliminate  from  the  so-called  "  gross 
income  "  all  items  which  are  in  the  nature  of  capital  receipts, 
such  as  additional  capital  invested,  money  borrowed,  real  estate 
or  fixtures  sold,  investments  (if  any)  matured  or  sold,  etc. 
The  payments  will  necessarily  have  to  be  analyzed  so  as  to 
state  the  totals  of  the  various  classes  of  deductions  allowed, 
and  to  eliminate  those  items  which  will  not  be  allowed  as 
deductions  from  the  gross  income.  This  last  group  will  consist 
of  such  items  as  loans  repaid,  interest  on  bonded  or  other 
indebtedness  exceeding  the  paid-up  capital  stock  of  the  corpo- 
ration, dividends  paid,  etc.  To  the  permissible  deductions  as- 
certained from  the  cash-book  will  be  added  an  allowance  for 
depreciation  of  property  and  any  losses  sustained  which  are 
not  represented  by  payments  made  in  the  year.  From  an  ac- 
counting standpoint,  however,  there  are  certain  losses  for 
which  credit  should  not  be  claimed.  Since  the  "  gross  income  " 
is  to  be  only  that  actually  collected  in  cash,  losses  by  bad  debts 
would  not  be  a  proper  deduction.  Depreciation  in  the  value 
of  merchandise  would  not  be  a  proper  deduction,  as  the  entire 


APPENDIX  G.  563 

cost  of  merchandise  will  be  claimed  as  a  deduction  when  pur- 
chased. 

Transportation  and  Public  Utility  Corporations  will  find 
their  principal  difficulty  in  making  returns  to  lie  in  the  treat- 
ment of  the  payments  for  stores,  *.  e.,  materials  and  supplies 
which  are  not  purchased  for  immediate  consumption,  but  which 
are  added  to  the  stock  necessary  to  be  kept  on  hand  and  forth- 
with lose  their  identity.  The  subsequent  use  of  the  stores  at 
times  long  subsequent  to  the  date  of  purchase  renders  it  imprac- 
ticable, in  fact,  impossible,  to  trace  most  of  the  stores  purchased 
to  their  ultimate  consumption  and  thus  determine  whether  the 
payments  therefor  are  "  ordinary  and  necessary  expenses 
.  .  .  in  the  maintenance  and  operation  of  its  business  and 
properties,"  or  are  for  construction  purposes  which  would  not 
be  allowed  as  a  deduction  from  the  gross  income  receipts. 
Hence,  it  follows  that  a  makeshift  must  be  adopted.  Two  op- 
tional courses  might  be  followed;  either  to  analyze  all  pay- 
ments for  stores,  eliminating  such  as  are  for  articles  which  it 
is  quite  certain  will  be  eventually  used  for  construction  pur- 
poses, the  remaining  payments  being  considered  as  on  account 
of  maintenance  or  operation,  or  to  deduct  from  the  total  pay- 
ments for  stores  purchased,  the  total  of  stores  issued  and 
charged  to  construction  during  the  year.  Either  course  will 
not  be  entirely  satisfactory,  but  over  a  period  of  years  the  latter 
would  give  more  accurate  results.  If  the  former  course  be 
followed,  many  payments  will  remain  in  the  expense  section, 
which  may  in  part,  at  least,  eventually  find  their  way  into  con- 
struction. This  is  unavoidable,  as  so  many  articles  purchased 
for  the  storeroom  are  used  for  both  construction  and  mainte- 
nance purposes. 

In  any  event  it  will  be  necessary  to  analyze  all  the  payments, 
and,  as  most  companies  of  this  kind  charge  the  bulk  of  them 
to  Accounts  or  Vouchers  Payable,  the  voucher  register  will 
have  to  be  consulted  for  the  distribution  between  construction, 
operation  and  maintenance,  taxes,  rentals,  interest  and  stores. 


$64  AUDITING. 

With  some  companies  the  distinction  between  rentals  and 
interest  will  be  a  very  important  one,  owing  to  the  limit  placed 
on  the  amount  of  debt,  the  interest  on  which  will  be  allowed 
as  a  deduction  from  gross  receipts.  When  interest  on  the 
bonds  of  an  underlying  company  is  paid  in  pursuance  of  a 
lease  by  which  the  parent  company  pays  such  interest  as  a 
rental  of  the  property,  such  interest  payments  should  be 
treated  as  rental,  and  the  bonded  debt  of  the  underlying  com- 
pany would  not  form  a  part  of  the  debt  on  which  interest  is 
only  allowed  as  a  deduction  up  "  to  an  amount  of  such  bonded 
or  other  indebtedness  not  exceeding  the  paid-up  capital  stock 
of  such  corporation/'  Where  there  has  been  an  actual  merger, 
however,  and  the  bonds  of  one  company  have  been  assumed 
by  another,  the  interest  paid  thereon  would  come  under  the 
head  of  interest  instead  of  rentals,  and  such  bonds  would  be 
taken  into  consideration  in  determining  the  amount  of  indebt- 
edness on  which  interest  will  be  allowed  as  a  deduction  from 
'  gross  income  received. 

Having  analyzed  the  cash  receipts  and  payments,  and  ascer- 
tained the  totals  of  income  receipts  and  the  various  classes  of 
payments  allowed  to  be  deducted  therefrom,  it  then  becomes 
necessary  to  consider  any  other  deductions  than  actual  pay- 
ments which  the  act  may  permit  to  be  made.  The  one  which 
suggests  itself  perhaps  first  is  depreciation  of  property,  the  act 
providing  for  the  deduction  of  "  a  reasonable  allowance  for 
depreciation  of  property."  It  is  to  be  hoped  that  this  clause 
of  the  corporation  tax  law  will  give  a  decided  impetus  to  the 
recognition  of  and  provision  for  depreciation  of  plant.  The 
i;endency  of  many  corporations  in  the  past  has  been  rather  to 
■'ignore  depreciation  than  to  make  an  excessive  allowance  there- 
for. Companies  operating  under  limited-term  franchises  for 
^which  value  has  been  paid  would  also  be  warranted  in  deduct- 
ing a  proportionate  part  of  such  cost  of  franchise.  Losses 
"  actually  sustained "  are  also  to  be  deducted  from  gross 
income  received.  Judging  from  the  Attorney-General's  letter 
of  1 2th  July,  in  the  case  of,  say,  damages  due  to  accidents,  the 


APPENDIX  G.  565 

deductions  should  be  based  on  the  accidents  occurring  within 
the  year  rather  than  on  damages  actually  paid,  thus  getting 
away  from  the  receipts  and  payments  basis  and  getting  nearer 
a  true  income  and  expense  basis.  Losses  due  to  bad  debts 
would  not  be  a  proper  deduction,  as  only  earnings  actually  col- 
lected in  cash  are  included  in  the  '*  gross  income."  Whether 
the  amortization  of  discount  on  bonds  will  be  permitted  to  be 
deducted  from  gross  income  may  perhaps  be  disputed.  Cer- 
tainly, from  an  accounting  and  common-sense  standpoint,  it 
ought  to  be,  as  it  is,  after  all,  only  interest  paid  in  advance. 

Manufacturing  or  Industrial  Corporations  will  find  the  most 
difficulty  in  making  a  return  which  will  comply  even  approxi- 
mately with  the  intent  of  the  new  law  as  expressed  by  the 
Attorney-General.  The  reasons  which  render  a  literal  compli- 
ance impossible  are  very  clearly  and  forcibly  stated  in  the 
accountants'  letter  of  21st  July.  Practically  all  the  factors 
already  considered  in  connection  with  other  classes  of  corpora- 
tions will  have  to  be  considered.  An  analysis  of  all  cash  re- 
ceipts and  payments  will  have  to  be  made,  eliminating  from  the 
receipts  everything  which  is  not  on  income  account.  From 
the  payments  will  have  to  be  eliminated  all  items  not  applying 
on  income  account,  such  as  loans  paid  off,  dividends  paid,  and 
all  items  which  can  be  identified  as  being  clearly  construction 
or  plant  items.  With  many  companies  which  have  a  complete 
stores  system  and  buy  materials  and  supplies  in  large  quan- 
tities, using  them  for  both  manufacturing  saleable  products 
and  additions  to  plant,  as  well  as  manufacturing  machinery 
for  their  own  use,  there  will  be  made  payments  for  labor, 
materials,  supplies,  etc.,  the  ultimate  disposition  of  which  it 
will  be  impossible  to  foretell  or  trace.  With  regard  to  these 
items,  all  that  can  be  done  is  to  exercise  the  best  judgment 
possible  and  to  do  it  in  good  faith.  The  separation  must  needs 
be  quite  arbitrary  in  many  instances,  and  naturally  income 
should  have  the  benefit  of  every  doubt. 

The  analysis  of  the  receipts  and  payments  will  be  followed 
by  the  determination  of  other  deductions   than  actual  cash 


566  AUDITING. 

payments  from  gross  income  permitted  by  the  law.  Deprecia- 
tion of  property  and  any  losses  not  represented  by  actual  pay- 
ments during  the  year  will  come  under  this  head.  Corporations 
which  have  issued  bonds  at  a  discount  will  also  need  to  con- 
sider the  disposition  of  the  discount,  which  has  already  been 
mentioned. 

The  blank  forms  on  which  the  Commissioner  of  Internal 
Revenue  will  require  returns  to  be  made  have  not  yet  been 
issued,  and  probably  will  not  be  until  1910,  as  the  first  year 
for  which  the  tax  must  be  paid  is  the  year  ending  31st  Decem- 
ber, 1909.  These  forms  will  probably  be  accompanied  by  rules 
to  be  observed  in  making  the  returns.  If,  however,  the  meth- 
ods followed  in  preparing  the  forms  correspond  with  the 
attitude  of  the  Attorney-General  (evidenced  by  his  corre- 
spondence with  the  accountants),  it  may  be  impossible  to  even 
approximate  a  correct  return  without  prohibitive  expense.  It 
is  to  be  expected  that,  on  account  of  the  difficulties  mentioned 
herein  and  for  other  reasons,  the  law  will  be  subjected  to 
judicial  scrutiny  and  interpretation,  which  may  modify  mate- 
rially some  of  the  impressions  first  created  by  the  law.  Cer- 
tainly, no  law  which  so  flagrantly  violates  the  principles  of 
true  accounting  will  stand  unchanged  for  many  years. 

It  is  to  be  hoped,  however,  that  the  foregoing  criticisms  and 
suggestions  will  be  found  interesting  and  perhaps  instructive 
to  the  student,  even  though  the  act  of  August  5,  1909,  may  be 
materially  modified  before  this  volume  has  been  off  the  press 
for  a  month. 


APPENDIX   G.  566  a 


Since  the  foregoing  was  written,  the  Treasury  Department 
has  issued  full  instructions  covering  the  returns  required, 
which  are  reprinted  here,  with  the  exception  of  certain  details 
of  interest  only  to  the  tax  collectors. 

It  will  be  noted  that  the  Attorney-General  of  the  United 
States  and  the  Secretary  of  the  Treasury  have  arrived  at 
interpretations  of  the  law  diametrically  opposite  to  each  other. 
Under  the  circumstances  it  will  not  be  strange  if  accountants 
and  corporation  officers  arrive  at  the  conclusion  that  the 
framers  of  the  law  could  not  possibly  have  produced  more 
confusion,  no  matter  how  hard  they  tried. 


The  Treasury  Department's  Explanation 

OF  THE 

Federal  Corporation  Tax  Law 


Regulations  Under  Which  the  Law  W^ill  Be  Administered 


Corporation  Excise  Tax 

PREPARATION  OF  BLANKS  AND  REGULATIONS. 

In  the  preparation  of  blanks  and  regulations  for  the  admin- 
istration of  the  Corporation  Excise  Tax,  provided  for  in  section 
38  of  the  tariff  act  of  August  5,  1909,  the  first  question  was  to 
ascertain  the  real  intent  of  the  law.  After  ascertaining  the 
real  intent  of  the  law,  the  problem  was  then  to  so  prepare  the 
forms  and  regulations  as  to  carry  out  that  intent  and  at  the 
same  time  avoid,  as  far  as  consistent,  unnecessary  and  unrea- 
sonable interference  with  ordinary  practices  of  business.  The 
standard  adopted  in  making  the   regulations   was  that  they 


566  b  AUDITING. 

should  be  fair,  just,  and  reasonable  to  the  taxpaying  corpora- 
tions as  well  as  to  the  Government. 

A  study  of  the  act  discloses  clearly  that  the  intent  of  the 
law  is  as  follows: 

1.  That  the  law  is  a  revenue  measure  and  should  be  con- 
strued liberally  for  the  purpose  of  producing  revenue  for  the 
Government. 

2.  That  the  real  intent  of  the  law  is  to  collect  a  tax  of  i 
per  cent  on  the  net  income,  less  $5,000  of  the  individual  cor- 
poration, joint-stock  company,  or  association  liable  to  the  tax. 

In  order  to  clearly  understand  the  intent  of  the  law  a  few 
primary  definitions  are  essential: 


NET  INCOME. 

The  term  "  net  income  "  as  used  in  this  law  means  not  only 
net  profits  arising  from  the  operation  of  the  principal  business 
of  the  corporation,  but  all  items  of  income  received  from  other 
sources,  such  as  investments,  holdings  in  other  companies,  and 
businesses,  etc.  The  expression  *'  net  income  "  is  used  because 
there  can  be  no  question  as  to  its  embracing  amounts  of  in- 
come received  from  these  outside  sources,  whereas  there  might 
be  some  question  as  to  whether  or  not  such  items  would  be 
included  in  the  expressions  "  net  profits  "  or  "  net  earnings." 

GROSS  INCOME. 

In  the  same  manner  the  term  "  gross  income  "  includes  gross 
profits,  the  expression  being  used  because  there  can  be  no 
question  but  what  it  embraces  all  items  of  income  received  by 
any  corporation  from  any  source,  while  there  might  be  some 
question  as  to  whether  "  gross  profits  "  or  "  gross  earnings  " 
would  embrace  such  items. 

A  great  amount  of  adverse  criticism  of  this  law  is  due  to 
misapprehension  of  the  proper  definitions  of  these  terms.  The 
opinion  was  advanced  that  because  "  gross  income  "  was  not 
"  gross  profits  "  it  must  be  "  gross  receipts,"  and  that,  in  the 


APPENDIX  G.  566  c 

same  way,  because  "  net  income  "  was  not  "  net  profits  "  it 
meant  "  net  receipts."  An  examination  of  the  law,  however, 
will  show  that  if  gross  income  meant  gross  receipts  the  statu- 
tory deductions  therefrom  would  not  leave  net  receipts,  but 
would  leave  merely  an  arbitrary  sum.  It  also  appeared  from 
calculations  that  if  these  interpretations  were  given  to  the 
law  from  mercantile  and  manufacturing  companies  alone  the 
amount  of  tax  received  would  be  many  times  the  sum  which 
was  estimated  to  be  collected  from  all  corporations,  joint- 
stock  companies,  and  associations  of  whatever  nature. 

It  is  clear,  therefore,  that  the  purpose  of  the  law  was  not 
to  put  a  tax  on  receipts,  but  a  tax  on  profits;  and  that  the 
terms  "  gross  income  "  and  "  net  income  "  are  used  because, 
while  they  are  practically  identical  with  "  gross  profits  "  and 
"net  profits,"  they  are  yet  more  embrasive  and  consequently 
permit  a  more  comprehensive  administration  of  the  law. 

The  law  requires  that  the  return  from  every  corporation, 
joint-stock  company,  and  association  liable  to  the  tax  shall 
show  the  "  gross  amount  of  the  income  *  *  *  received 
during  the  year  from  all  sources,"  and  authorizes  certain  de- 
ductions such  as  "  ordinary  and  necessary  expenses  actually 
paid  out  of  earnings  in  the  business  and  property  of  such 
corporations  *  *  *  within  the  year;  all  losses  sustained 
during  the  year;  amount  of  interest  actually  paid  within  the 
year;  amount  paid  by  it  within  the  year  for  taxes;  amount 
received  within  the  year  as  dividends  upon  stock  of  other 
corporations  liable  to  this  tax,  etc." 

Very  careful  consideration  has  been  given  to  these  expres- 
sions in  order  to  determine  what  evidence  shall  be  required  in 
order  to  determine  what  items  are  to  be  considered  as 
"  income "  in  calculating  "  gross  income,"  and  what  items 
should  be  allowed  as  deductions  under  the  language  of  the 
law.  An  impression  has  obtained  in  some  quarters  that  no 
item  should  be  considered  in  making  up  the  account  of  the 
corporation,  either  as  income  or  a  deduction,  unless  its  receipt 
or  disbursement  was  evidenced  by  an  actual  cash  transaction. 
It  was  owing  to  this  interpretation  placed  on  the  law  that  a 


566  d  AUDITING. 

great  number  of  accountants  throughout  the  country  declared 
that  the  law  was  impossible  of  administration,  and  if  their  in- 
terpretation of  the  law  had  been  correct,  there  would  indeed 
have  been  the  most  serious  difficulty. 

Upon  first  reading  the  law  and  studying  the  authorities  re- 
lating to  the  language  used,  it  would  appear  that  the  words 
admit  of  no  interpretation  other  than  that  an  item  must  have 
been  evidenced  by  the  actual  disbursement  of  cash,  or  some- 
thing of  equal  value,  before  it  could  be  considered  in  making 
up  the  account  of  a  corporation.  It  is  interesting  to  note, 
however,  that  all  definitions  and  decisions  regarding  the 
expression  "  actually  paid,"  consider  the  matter  from  the 
standpoint  of  debtor  and  creditor,  and  not  from  the  standpoint 
of  the  individual  himself,  or  in  this  case,  from  within  a  cor- 
poration concerned  solely  with  its  own  accounts  from  which 
alone  the  law  requires  this  return  for  taxation  to  be  made,  and 
not  taking  into  consideration  the  standpoint  of  the  debtor. 

It  is  clear  that  to  hold  that  the  phrase  "  actually  paid  within 
the  year "  requires  evidence  of  actual  disbursement  in  cash 
during  the  year  would  prohibit  anything  like  accurate  returns 
being  made  by  any  corporation,  and  would  render  it  impos- 
sible to  carry  out  what  is  the  main  purpose  of  the  law,  because 
to  subtract  from  the  gross  income  the  deductions  specified  in 
the  statute,  calculated  on  a  cash  basis,  would  give  net  income, 
on  which  the  tax  is  to  be  measured,  only  when  the  entire  busi- 
ness transacted  by  the  corporation  is  done  in  cash  and  the  trans- 
actions are  completed  every  day.  It  is  not  believed  that  there 
is  any  such  corporation  in  existence.  The  return,  predicated 
on  gross  income  received  in  cash  and  deductions  represented 
by  cash  transactions  will  vary  from  the  real  net  income  some- 
what in  proportion  as  the  business  transacted  by  the  corpora- 
tion varies  from  the  absolutely  cash  basis. 

This  is  viewing  the  matter  in  its  simplest  aspect.  When  we 
contemplate  the  complications  and  intricacies  of  the  business 
affairs  of  a  great  corporation,  with  its  many  dealings  with 
other  corporations  and  individuals  which  are  never  settled  in 
cash,  but  are  settled  on  somewhat  the  clearing-house  plan ; 


APPENDIX  G.  566  e 

its  many  advances  of  funds  and  long-deferred  statements  of 
accounts,  purchases  of  supplies  and  materials  at  one  time, 
which  are  mixed  with  supplies  and  materials  already  on  hand 
and  those  purchased  at  other  times,  and  which  are  used  and 
disbursed  without  any  relation  to  their  time  of  purchase,  any 
attempt  to  follow  each  of  these  transactions  out  into  the  cash- 
book  and  to  settle  the  accounts  of  such  complicated  actions  of 
a  corporation  on  the  cash  book  instead  of  on  the  ledger,  would 
result  in  inextricable  confusion,  uncertainty,  and  inaccuracy, 
and  the  friction  occasioned  the  business  world  by  such  an  at- 
tempt would  be  a  very  serious  proposition. 

Relating  to  statutory  deductions,  the  regulation  is  to  the 
effect  that  the  deductions  authorized  shall  include  all  expense 
items  under  the  various  heads  acknowledged  as  liabilities  by 
the  corporation  making  the  return  and  entered  as  such  on  its 
books  from  January  i  to  December  31  of  the  year  for  which 
return  is  made.  It  will  appear,  therefore,  that  the  return  is  to 
be  made  up  from  the  ledger  and  not  the  cash  book,  and  that 
entry  on  the  ledger  from  January  i  to  December  31  of  the 
year  for  which  return  is  made  is  the  evidence  which  will  deter- 
mine whether  or  not  an  item  is  to  be  taken  account  of  in  mak- 
ing the  return. 

It  is  believed  that  this  interpretation  furnishes  a  practical 
working  method  by  which  the  amount  of  income  subject  to 
the  tax  can  be  fairly  and  justly  determined  in  every  case. 

Of  course,  in  administering  a  law  applying  to  so  many  tax- 
payers (lists  prepared  by  collectors  show  something  over 
400,000  corporations  which  will  have  to  make  returns)  some 
of  the  returns  will  be  inaccurate.  The  causes  of  inaccuracy 
will  be  two :  First,  honest  error ;  second,  wilful  intent  to  de- 
fraud the  Government  of  revenue.  If  an  honest  error  is  made 
in  calculating  the  return  for  one  year,  it  will  be  corrected  if 
possible,  and  even  if  not  corrected  in  one  year  it  would  more 
than  probably  correct  itself  later.  Where  fraudulent  purpose 
is  discovered,  vigorous  prosecution  will  follow.  This  bureau 
feels  that  in  dealing  with  the  incorporated  business  of  the 
country  it  is  dealing,  in  the  main,  with  honest  men.     However, 


566  f  AUDITING. 

the  regulations  are  drawn  sufficiently  rigid  to  restrain  anyone 
who  does  not  measure  up  to  this  standard. 

The  regulations  do  not  call  for  specific  methods  of  keeping 
accounts  or  any  particular  method  of  bookkeeping ;  the  require- 
ment is  simply  that  the  transaction  be  so  recorded  that  accurate 
returns  can  be  made  therefrom  and  verified  when  necessary. 

In  many  corporations,  mercantile  and  manufacturing  partic- 
ularly, an  inventory,  or  its  equivalent,  is  essential  at  the  close  of 
each  calendar  year.  The  law  specifically  states  that  the  tax 
shall  be  collected  for  the  calendar  year  and  no  return  for  any 
other  period  can  be  accepted.  Provision  is,  however,  made  for 
preparing  returns  for  the  present  year,  when  no  inventory  or 
equivalent  was  taken  at  close  of  last  calendar  year.  Provision 
is  made  for  a  method  of  fairly  determining  amount  of  loss  and 
depreciation  claimed;  also  for  a  fair  adjustment  of  profit  or 
loss  in  case  of  sale  of  capital  assets  acquired  prior  to  January 
I,  1909;  also  for  properly  accounting  for  materials  and  sup- 
plies, etc. 

Great  numbers  of  communications  have  been  received  rela- 
tive to  the  publicity  clause.  While  there  is  apparently  some 
inconsistency  between  the  two  paragraphs  of  the  law  relating 
to  making  public  the  information  received,  the  language  of  the 
law  relating  to  filing  returns  for  record  and  public  inspection  is 
so  clear  that  the  Bureau  of  Internal  Revenue  has  no  discretion 
whatever  in  the  matter. 

The  forms  and  regulations  will  go  to  the  collector  of  each 
district,  who  will  send  copies  of  the  blanks  and  a  copy  of  the 
regulations  to  every  corporation  whose  name  and  address  the 
collector  has  been  able  to  secure.  Failure  to  receive  the  blanks 
or  any  notice  relative  thereto  will  not  excuse  a  corporation 
from  making  the  return  required  by  law,  nor  will  it  relieve  it 
from  penalties  for  failure  so  to  do.  If  copies  of  blanks  and 
regulations  are  not  received  on  or  about  January  i,  application 
should  be  made  to  the  collector  in  whose  district  the  prinicipal 
office  of  the  corporation  is  located,  so  that  the  return  can  be  in 
the  hands  of  the  collector  by  the  time  required  in  the  statute. 

The  regulations  issued  by  the  Commissioner  of  Internal 
Revenue  are  as  follows : 


APPENDIX    G.  566  g 

REGULATIONS 

Relative  to 

Excise  Tax  on  Corporations,  Joint  Stock  Companies,  Associa- 
tions and  Insurance  Companies. 


Imposed  by  authority  of  Section  38,  Act  of  August  5,  1909. 


Article  I. 


The  attention  of  collectors  and  others  is  specially  called  to 
the  fact  that  the  tax  imposed  by  this  section  of  the  law  applies 
to  all  corporations,  joint-stock  companies,  associations,  or  in- 
surance companies  described  (except  those  specifically  ex- 
empted), without  reference  to  the  kind  of  business  carried 
on,  and  that  the  tax  is  to  be  computed  upon  the  net  income 
of  such  corporations,  joint-stock  companies,  associations,  and 
insurance  companies,  which  shall  be  calculated  by  subtracting 
from  the  gross  income  received  from  all  sources  during  the 
year  certain  deductions  specifically  set  forth  in  the  statute. 

Every  corporation,  joint-stock  company,  association,  or  in- 
surance company  not  specifically  enumerated  as  exempt  shall 
make  the  return  required  by  law,  whether  it  may  have  net 
income  liable  to  tax  or  not. 

In  the  case  of  corporations,  joint-stock  companies,  associa- 
tions or  insurance  companies  organized  under  the  authority 
of  the  United  States  or  any  State  or  Territory  thereof,  includ- 
ing Alaska  and  District  of  Columbia,  such  net  income  relates 
not  only  to  the  business  carried  on  within  the  confines  of  the 
United  States,  but  to  income  received  from  business  trans- 
acted in  any  foreign  country  as  well.  In  case  of  corporations, 
joint-stock  companies,  and  associations  organized  under  the 
authority  of  foreign  countries  the  terms  "  Gross  income,"  "  Net 
income,"  and  "  Authorized  deductions  "  relate  only  to  business 
transacted  within  the  United  States  or  any  state  or  territory 
thereof. 


566  h  AUDITING. 

Article  2. — Gross  Income. 

The  following  definitions  and  rules  are  given  for  deter- 
mining the  gross  income  of  the  various  classes  of  corporations  : 

I  A.  Banks  and  other  financial  institutions. — Gross  income 
consists  of  the  gross  revenue  derived  from  the  operation  and 
management  of  the  business  and  property  of  the  corporation 
making  the  return,  together  with  all  amounts  of  income  (in- 
cluding dividends  received  on  stock  of  other  corporations, 
joint-stock  companies,  associations,  and  insurance  companies 
subject  to  this  tax)  derived  from  all  other  sources,  as  shown 
by  the  entries  on  its  books  from  January  i  to  December  31  of 
the  year  for  which  return  is  made. 

I  B.  Insurance  companies. — Same  as  I  A  above. 

2.  Transportation  companies. — Same  as  i  A  above. 

3.  Manufacturing  companies. — Gross  income  received  dur- 
ing the  year  from  all  sources  will  consist  of  the  total  amount, 
ascertained  through  an  accounting,  that  shows  the  difference 
between  the  price  received  for  the  goods  as  sold  and  the  cost 
of  such  goods  as  manufactured.  The  cost  of  goods  manu- 
factured shall  be  ascertained  by  an  addition  of  a  charge  to  the 
account  of  the  cost  of  goods  as  manufactured  during  the  year 
of  the  sum  of  the  inventory  at  beginning  of  the  year  and  a 
credit  to  the  account  of  the  sum  of  the  inventory  at  the  end 
of  the  year.  To  this  amount  should  be  added  all  items  of 
income  received  during  the  year  from  other  sources,  including 
dividends  received  on  stock  of  other  corporations,  joint-stock 
companies,  associations,  and  insurance  companies  subject  to 
this  tax.  In  the  determination  of  the  cost  of  goods  manufac- 
tured and  sold  as  above  such  cost  shall  comprehend  all  charges 
for  maintenance  and  operation  of  manufacturing  plant,  but 
shall  not  embrace  allowances  for  depreciation  of  property  nor 
for  losses  sustained  which  are  to  be  taken  account  of  in  ascer- 
taining the  net  income  subject  to  tax  under  the  proper  heading 
in  the  authorized  deductions. 

4.  Mercantile  companies. — Gross  amount  of  income  received 
during  the  year  from  all  sources  consists  of  the  total  amount 


APPENDIX   G.  566! 

ascertained  through  inventory,  or  its  equivalent,  which  shows 
the  difference  between  the  price  received  for  goods  sold  and 
the  cost  of  goods  purchased  during  the  year,  with  an  addition 
of  a  charge  to  the  account  of  the  sum  of  the  inventory  at 
beginning  of  -the  year  and  a  credit  to  the  account  of  the  sum 
of  the  inventory  at  the  end  of  the  year.  To  this  amount  should 
be  added  all  items  of  income  received  during  the  year  from 
other  sources  inclusive  of  dividends  received  on  stock  of  other 
corporations,  joint-stock  companies,  associations,  and  insurance 
companies  subject  to  this  tax.  In  determining  this  amount  no 
account  shall  be  taken  of  allowances  for  depreciation  of  prop- 
erty, nor  for  losses  sustained  which  are  to  be  taken  account  of 
in  ascertaining  the  net  income  subject  to  tax  under  the  proper 
heading  in  the  authorized  deductions. 

5.  Miscellaneous. — Gross  income  consists  of  the  gross  rev- 
enue derived  from  the  operation  and  management  of  the  busi- 
ness and  property  of  the  corporation  making  the  return, 
together  with  all  amounts  of  income  (including  dividends 
received  on  stock  of  other  corporations,  joint-stock  companies, 
associations,  and  insurance  companies  subject  to  this  tax) 
derived  from  all  other  sources  as  shown  by  the  entries  on  the 
books  from  January  i  to  December  31  of  the  year  for  which 
return  is  made. 

It  will  be  noted  from  these  definitions  that  gross  income  is 
practically  the  same  as  gross  profits,  the  only  difference  being 
that  gross  income  is  more  inclusive,  embracing  as  it  does  not 
only  gross  profits  of  the  corporation,  joint-stock  company  and 
association  itself,  but  also  all  amounts  of  income  received  from 
other  sources.  It  is  immaterial  whether  any  item  of  gross 
income  is  evidenced  by  cash  receipts  during  the  year  or  in 
such  other  manner  as  to  entitle  it  to  proper  entry  on  the  books 
of  the  corporation  from  January  i  to  December  31  for  the  year 
in  which  return  is  made. 

Sale  of  capital  assets. — In  ascertaining  income  derived  from 
the  sale  of  capital  assets,  if  the  assets  were  acquired  subsequent 
to  January  i,  1909,  the  difference  between  the  selling  price 
and  the  buying  price  shall  constitute  an  item  of  gross  income 


566  j  AUDITING. 

to  be  added  to  or  subtracted  from  gross  income  according  to 
whether  the  selling  price  was  greater  or  less  than  the  buying 
price.  If  the  capital  assets  were  acquired  prior  to  January  i, 
1909,  the  amount  of  increment  or  depreciation  representing  the 
difference  between  the  selling  and  buying  price  is  to  be  adjusted 
so  as  to  fairly  determine  the  proportion  of  the  loss  or  gain 
arising  subsequent  to  January  i,  1909,  and  which  proportion 
shall  be  deducted  from  or  added  to  the  gross  income  for  the 
year  in  which  the  sale  was  made.  But  for  the  purpose  of  de- 
termining the  selling  price,  as  provided  in  this  section,  there 
shall  be  added  to  the  price  actually  realized  on  sale  any  amount 
which  has  already  been  set  aside  and  deducted  from  gross 
income  by  way  of  depreciation  as  defined  in  article  4,  and  has 
not  been  paid  out  in  making  good  such  depreciation  on  the 
property  sold. 

Where  a  corporation  is  engaged  in  carrying  on  more  than 
one  class  of  business,  gross  income  derived  from  the  different 
classes  of  business  shall  be  ascertained  according  to  the  defini- 
tions above,  applicable  thereto. 

Article  3. — Net  Income. 

"  Net  income  shall  be  ascertained  by  deducting  from  the 
gross  amount  of  the  income  of  such  corporation,  joint-stock 
company  or  association,  or  insurance  company,  received  within 
the  year  from  all  sources,  (first)  all  the  ordinary  and  necessary 
expenses  actually  paid  within  the  year  out  of  income  in  the 
maintenance  and  operation  of  its  business  and  properties, 
including  all  charges  such  as  rentals  or  franchise  payments 
required  to  be  made  as  a  condition  to  the  continued  use  or 
possession  of  property;  (second)  all  losses  actually  sustained 
within  the  year  and  not  compensated  by  insurance  or  other- 
wise, including  a  reasonable  allowance  for  depreciation  of  prop- 
erty, if  any,  and  in  the  case  of  insurance  companies  the  sums 
other  than  dividends,  paid  within  the  year  on  policy  and 
annuity  contracts  and  the  net  addition,  if  any,  required  by  law 
to  be  made  within  the  year  to  reserve  funds ;  (third)  interest 


APPENDIX    G.  566  k 

actually  paid  within  the  year  on  its  bonded  or  other  indebted- 
ness to  an  amount  of  such  bonded  and  other  indebtedness  not 
exceeding  the  paid-up  capital  stock  of  such  corporation,  joint- 
stock  company  or  association,  or  insurance  company,  outstand- 
ing at  the  close  of  the  year,  and  in  the  case  of  a  bank,  banking 
association,  or  trust  company,  all  interest  actually  paid  by  it 
within  the  year  on  deposits."  In  case  of  corporations,  joint- 
stock  companies,  and  associations  organized  under  the  laws 
of  a  foreign  country,  "  the  proportion  of  its  paid-up  capital 
stock  outstanding  at  the  close  of  the  year  which  the  gross 
amount  of  its  income  for  the  year  from  business  transacted 
and  capital  invested  within  the  United  States  and  any  of  its 
Territories,  Alaska,  and  the  District  of  Columbia,  bears  to  the 
gross  amount  of  its  income  derived  from  all  sources  within 
and  without  the  United  States;  (fourth)  all  sums  paid  by  it 
within  the  year  for  taxes  imposed  under  the  authority  of  the 
United  States  or  of  any  State  or  Territory  thereof,  or  imposed 
by  the  government  of  any  foreign  country  as  a  condition  to 
carrying  on  business  therein;  (fifth)  all  amounts  received  by 
it  within  the  year  as  dividend  upon  stock  of  other  corporations, 
joint-stock  companies  or  associations,  or  insurance  companies, 
subject  to  the  tax  hereby  imposed." 

The  section  further  provides: 

That  in  the  case  of  a  corporation,  joint-stock  company,  or 
association,  or  insurance  company,  organized  under  the  laws 
of  a  foreign  country,  such  net  income  shall  be  ascertained  (by 
making  like  deductions)  from  the  gross  amount  of  its  income 
received  within  the  year  from  business  transacted  and  its 
capital  invested  within  the  United  States  and  any  of  its  Terri- 
tories, Alaska,  and  the  District  of  Columbia. 

Also  that : 

In  the  case  of  assessment  insurance  companies  the  actual 
deposit  of  sums  with  state  or  territorial  officers,  pursuant  to 
law,  as  additions  to  guaranty  or  reserve  fund,  shall  be  treated 
as  being  payments  required  by  law  to  reserve  fund. 

Also   (third  paragraph)   that: 

There  shall  be  deducted  from  the  amount  of  the  net  income 


5661  AUDITING. 

of  each  of  such  corporations,  joint-stock  companies,  or  asso- 
ciations, or  insurance  companies,  ascertained  as  provided  in 
the  foregoing  paragraphs  of  this  section,  the  sum  of  five 
thousand  dollars. 

The  net  income,  therefore,  is  the  remainder  of  the  gross 
income  after  making  the  specified  deductions. 

Article  4. — Deductions. 

The  specified  deductions  actually  paid  within  the  year,  set 
forth  in  the  statute  and  as  described  in  Article  3  preceding, 
shall  include  all  proper  items  of  expenses  and  charges  under 
the  respective  heads  as  designated.  The  amount  returned  for 
ordinary  and  necessary  expenses  actually  paid  within  the  year 
out  of  income  in  maintenance  and  operation  of  the  business 
and  properties  of  the  corporation  should  not,  however,  embrace 
allowances  for  depreciation  of  fixed  property  which  are  other- 
wise to  be  taken  account  of  under  the  proper  heading  in  the 
authorized  deductions,  nor  expenses  paid  within  the  year  and 
charged  to  such  allowances  for  depreciation  credited  in  the 
current  year  or  in  previous  years.  In  ascertaining  expenses 
proper  to  be  included  in  the  deductions  to  be  made  under  this 
article,  corporations  carrying  materials  and  supplies  on  hand 
for  use  should  include  in  such  expenses  the  charges  for  mate- 
rials and  supplies  only  to  the  amount  that  the  same  are  actu- 
ally disbursed  and  used  in  operation  and  maintenance  during 
the  year  for  which  the  return  is  made. 

It  is  immaterial  whether  the  deductions  are  evidenced  by 
actual  disbursements  in  cash,  or  whether  evidenced  in  such 
other  way  as  to  be  properly  acknowledged  by  the  corporate 
officers  and  so  entered  on  the  books  as  to  constitute  a  liability 
against  the  assets  of  the  corporation,  joint-stock  company, 
association,  or  insurance  company  making  the  return. 

Losses. — The  deduction  for  losses  must  be  in  respect  of 
losses  actually  sustained  during  the  year  and  not  compensated 
by  insurance  or  otherwise.  It  must  be  based  upon  the  differ- 
ence between  the  cost  value  and  salvage  value  of  the  property 


APPENDIX   G.  566  m 

or  assets,  including  in  the  latter  value  such  amount,  if  any, 
as  has  in  the  current  or  previous  years  been  set  aside  and  de- 
ducted from  gross  income  by  way  of  depreciation  as  defined  in 
the  following  section  and  not  been  paid  out  in  making  good 
such  depreciation. 

Depreciation. — The  deduction  for  depreciation  should  be  the 
estimated  amount  of  the  loss,  accrued  during  the  year  to  which 
the  return  relates,  in  the  value  of  the  property  in  respect  of 
which  such  deduction  is  claimed  that  arises  from  exhaustion, 
wear  and  tear,  or  obsolescence  out  of  the  uses  to  which  the 
property  is  put,  and  which  loss  has  not  been  made  good  by  pay- 
ments for  ordinary  maintenance  and  repairs  deducted  under  the 
heading  of  expenses  of  maintenance  and  operation  or  in  the 
ascertainment  of  gross  income.  This  estimate  should  be 
formed  upon  the  assumed  life  of  the  property,  its  cost  value, 
and  its  use.  Expenses  paid  in  any  one  year  in  making  good 
exhaustion,  wear  and  tear,  or  obsolescence  in  respect  of  which 
any  deduction  for  depreciation  is  claimed  must  not  be  included 
in  the  deduction  for  expense  of  maintenance  and  operation  of 
the  property  or  in  the  ascertainment  of  gross  income,  but  must 
be  made  out  of  accumulative  allowances  deducted  for  depre- 
ciation in  current  and  previous  years. 


Article  5. — Inventories. 

It  will  be  noted  that  an  inventory  or  its  equivalent  of  mate- 
rials, supplies,  and  merchandise  on  hand  for  use  or  sale  at  the 
close  of  each  calendar  year  is  essential  in  the  case  of  certain 
corporations  in  order  to  determine  the  gross  income,  and  in 
case  of  other  corporations  to  determine  their  expenses  of  opera- 
tion. Where  such  inventory  or  its  equivalent  was  not  taken 
at  the  close  of  the  year  1908,  a  supplemental  statement  showing 
such  inventory  approximately  must  be  submitted  with  the  re- 
turn on  the  regular  form.  Such  supplemental  statement  shall 
be  verified  under  oath  by  the  treasurer  or  principal  financial 
officer  in  submitting  the  same. 

Where  any  item  under  any  of  the  deductions  is  of  an  un- 


566  n  AUDITING. 

usual  nature  a  special  explanatory  note  referring  to  such 
item  shall  be  made  and  attached  to  the  form  at  the  appropriate 
place  and  made  a  part  thereof  by  proper  reference. 

Paragraph  3  of  said  Section  38  also  provides : 
and  said  tax  shall  be  computed  upon  the  remainder  of  said  net 
income  of  such  corporation,  joint-stock  company  or  association, 
or  insurance  company,  for  the  year  ending  December  thirty- 
first,  nineteen  hundred  and  nine,  and  for  each  calendar  year 
thereafter;  and  on  or  before  the  first  day  of  March  nineteen 
hundred  and  ten,  and  the  first  day  of  March  in  each  year  there- 
after, a  true  and  accurate  return  under  oath  or  affirmation  of 
its  president,  vice-president,  or  other  principal  officer,  and  its 
treasurer  or  assistant  treasurer,  shall  be  made  by  each  of  the 
corporations,  joint-stock  companies  or  associations,  and  insur- 
ance companies,  subject  to  the  tax  imposed  by  this  section,  to 
the  collector  of  internal  revenue  for  the  district  in  which  such 
corporation,  joint  stock  company  or  association,  or  insurance 
company,  has  its  principal  place  of  business,  or,  in  the  case  of 
a  corporation,  joint  stock  company  or  association,  or  insurance 
company,  organized  under  the  laws  of  a  foreign  country,  in 
the  place  where  its  principal  business  is  carried  on  within  the 
United  States,  in  such  form  as  the  Commissioner  of  Internal 
Revenue,  with  the  approval  of  the  Secretary  of  the  Treasury, 
shall  prescribe. 

Each  return  so  made  is  required  to  set  forth : 

(a)  The  total  amount  of  the  paid-up  capital  stock  of  such 
corporations,  joint-stock  companies  or  associations,  or  insur- 
ance companies,  outstanding  at  the  close  of  the  year ; 

(b)  The  total  amount  of  bonded  and  other  indebtedness  of 
such  corporation,  joint-stock  company  or  association,  or  insur- 
ance company,  at  the  close  of  the  year ; 

(c)  The  gross  amount  of  the  income  of  such  corporation, 
joint-stock  company  or  association,  or  insurance  company,  re- 
ceived during  the  year  from  all  sources,  and  if  organized  under 
the  laws  of  a  foreign  country,  the  gross  amount  of  its  income 
received  within  the  year  from  business  transacted  and  capital 


APPENDIX  G.  5660 

invested  within  the  United  States  and  any  of  its  territories, 
Alaska,  and  the  District  of  Columbia. 

Such  returns  are  also  required  to  set  forth  the  items  claimed 
as  deductions  (Article  4),  also  the  net  income  after  such  de- 
ductions have  been  made. 


Article  6. 

Under  the  authority  conferred  by  this  act  forms  of  return 
have  been  prescribed,  in  which  the  various  items  specified  in 
the  law  are  to  be  stated. 

Blank  forms  of  this  return  will  be  mailed  to  collectors  and 
should  be  furnished  to  every  corporation,  not  expressly  ex- 
cepted, on  or  before  January  i,  19 10,  and  on  or  before  Janu- 
ary I  of  each  year  thereafter.  Failure  on  the  part  of  any  cor- 
poration, joint-stock  company,  association,  or  insurance  com- 
pany liable  to  this  tax,  to  receive  a  blank  form  will  not  excuse 
it  from  making  the  return  required  by  law,  or  relieve  it  from 
any  penalties  for  failure  to  make  the  return  in  the  prescribed 
time.  Corporations  not  supplied  with  the  proper  forms  for 
making  the  return  should  make  application  therefor  to  the  col- 
lector of  internal  revenue  in  whose  district  is  located  its  prin- 
cipal place  of  business.  Each  corporation  should  carefully 
prepare  its  return  so  as  to  fully  and  clearly  set  forth  the  data 
therein  called  for. 

Bookkeeping. — No  particular  system  of  bookkeeping  or  ac- 
counting will  be  required  by  the  Department.  However,  the 
business  transacted  by  corporations,  joint-stock  companies, 
associations,  or  insurance  companies  must  be  so  recorded  that 
each  and  every  item  therein  set  forth  may  be  readily  verified 
by  an  examination  of  the  books  and  accounts,  where  such 
examination  is  deemed  necessary. 

Calendar  year. — As  the  law  specifically  provides  that  the  tax 
imposed  shall  be  computed  on  the  net  income  during  each 
"  calendar  year,"  returns  of  income  based  on  any  period  other 
than  the  calendar  year  can  not  be  accepted. 


566  p  AUDITING. 

Corporations  organized  during  the  year  or  going  into  liqui- 
dation during  the  year  should  nevertheless  render  a  sworn 
return  on  the  prescribed  form. 


Royal  E.  Cabell,  Commissioner. 

Approved : 

Franklin  MacVeagh, 

Secretary  of  the  Treasury. 


INDEX. 


Accountants,  Opinion  of,  on  extent  of  investigations,  319 
Accounts,  Corrections  in,  31 

of  Architects,  Points  in  the  audit  of,  165 

Banks,  Points  in  audit  of,  114 

Branch  Establishments,  82 

Breweries,  Points  in  audit  of,  96 

Building  and  Loan  Societies,  Points  in  audit  of,  161 

Cash  Businesses,  Points  in  audit  of,  93 

Churches,  Points  in  audit  of,  159 

Clubs,  Points  in  audit  of,  99 

Colleges  and  Schools,  Points  in  audit  of,  160 

Collieries,  Points  in  audit  of,  109 

Commercial,  .91 

Consignments,  81 

Contractors,  Points  in  audit  of,  95 

Cost,  59 

Electric  Lighting  Bodies,  Points  in  audit  of,  141 
"         Railways,  Points  in  audit  of,  146 

Executors  and  Trustees,  Points  in  audit  of,  155 

Financial  Undertakings,  Points  in  audit  of,  114 

Fire  Insurance  Companies,  Points  in  audit  of,  122 

Gas  Companies,  Points  in  audit  of,  139 

Gold  Mines,  &c.,  112 

Hotels,  Points  in  audit  of,  98 

Institutions,  Points  in  audit  of,  158 

Insurance  Companies,  Points  in  audit  of,  121 

Investment  Companies,  126 

Lawyers,  Points  in  audit  of,  164 

Life  Insurance  Companies,  Points  in  audit  of,  124 

Manufacturing  Traders,  Points  in  audit  of,  92 

Medical  Men,  Points  in  audit  of,  160 

Merchants,  Wholesale,  Points  in  audit  of,  91 

Mines,  Points  in  audit  of,  109 

Newspapers,  Points  in  audit  of,  107 

567 


568  INDEX. 

Accounts  of  Public  Authorities,  Points  in  audit  of,  152 

Public  Service  Corporations,  Points  in  audit  of,  132 
Publishers,  Points  in  audit  of,  105 
Railways,  Points  in  audit  of,  142 
Restaurants,  Points  in  audit  of,  99 
Retailers,  Points  in  audit  of,  92 
Shipping  Companies,  Points  in  audit  of,  150 
Single-ship  Companies,  Points  in  audit  of,  152 
Speculative  Finance  Companies,  Points  in  audit  of,  132 
Steam  Railways,  Points  in  audit  of,  143 
Street  Railways,  Points  in  audit  of,  145 
Stockbrokers,  Points  in  audit  of,  129 
Stores  and  Stock,  Points  in  audit  of,  71 
Theatres,  Points  in  audit  of,  loi 
Theatrical  Companies,  Points  in  audit  of,  103 
Traders,  Points  in  audit  of,  73,  211 

Trust  and  Investment  Companies,  Points  in  audit  of,  126 
Water  Companies,  Points  in  audit  of,  141 
Published  form  of.  Auditor's  duty  as  regards,  206,  239 
Action  against  auditors.  Procedure  by  way  of,  310 
Additions  and  betterments  expenditures,  Steam  Railways,  143 

"         Checking,  32 
Adjustments  of  profits  in  investigations  as  to  profits,  322 
Advantages  of  a  "completed  audit,"  28 
"  "continuous  audit,"  28 

"  an  audit,  25 

"  double-entry  bookkeeping,  246 

"  keeping  proper  Stock  Accounts,  7 1 

"  making  each  Ledger  self -balancing,  66 

"  opening  Suspense  Accounts,  76 

"  statistical  information,  215 

Tabular  Cash  Book,  60 
"  use  of  an  Audit  Note  Book,  17 

After  discovered  evidence,  205 
Agency  Accoimts,  Treatment  of,  81 
Agents'  Accounts,  80 

Agreement,  Partnership,  Points  to  be  considered  in  drawing  up,  85 
Agreements,   Hire-Purchase,  185 

"  Partnership,  85 

Alterations  during  audit.  Methods  of  detecting  fraudulent,  45 
Amateur  auditors,  266 
American  Malting  case,  180,  250,  386 
Amortization,  50 
Amount  of  reserve  necessary  for  insurance  company,  122 


INDEX.  569 

Annuity  system  of  depreciation,  190 

Annuity  Tables,  Charles  E.  Sprague  on,  190 

Anticipated  Profits,  181 

Appleton  V.  American  MalUng  Company,  case  considered,  250 

Apportionment  between  capital  and  revenue,  Examples  of,  136 

"  of  capital  and  income  in  Executorship  Accounts,  155 

Architects,  Accounts  of,  Points  in  audit  of,  165 
Arrears  of  cumulative  preference  dividends,  Treatment  of,  184 
■Assets  and  liabilities.  Reason  for  transposing  in  Balance  Sheet,  217 
"         "    secret  reserves,  Fluctuations  in,  203 
"      Auditor's  duty  with  regard  to  writing-up  of,  203 
' '      Definition  of  term,  216 
"      in  books  of  account.  Methods  of  depreciating,  187,  217 

Legality  of  writing-up,  203 
"      of  bank.  Method  of  vouching,  11^4 
"      Outstanding,  Verification  of,  182 
"      Principle  in  valuation  of,  169,  225 
"      Side  of  Balance  Sheet,  220 
"      Verification  of  existence  of,  114,  174 
Astrachan  Steamship  Company,  case  considered,  311 
Attorney-General  of  U.  S.  Correspondence  re  Corporation  Tax,  549 
Audit,  system  of  conducting  an,  1 7 
clerks,  Qualifications  of,  275 
completed.  Disadvantages  of  a,  28 
continuous.  Description  of,  28 

"  Disadvantages  of  a,  28 

Detection  of  fraud  as  an  object  of  an,  22 
fee.  Treatment  of,  in  accounts,  184 
Importance  of  ascertaining  general  system  under,  24 
Instructions  as  to  preparation  for,  88 

"  for,  20 

Limitation  of,  270 
Method  of  an,  28 

New,  Duties  of  principal  at  commencement  of,  2 1 
not  an  insurance  against  fraud,  270 
Note  Book,  description  of,  17,  19 

form  of,  18 
Object  and  scope  of  an,  22 
of  brewery,  saloons  in  connection  with,  97 
Capital  Stock  Accoimts,  49 
Corporations  Accounts,  48 
payments  for  dividend  or  interest,  5 1 
Purchase  Ledgers  of  retailer,  93 
railway,  Programme  of,  145 
Sales  Ledgers  of  retailer,  92 


570  .  '  INDEX. 

Audit  of  trust  companies,  Valuation  of  investments  in,  121 
"      Stamps,  Rubber,  42 

"      System  on  which,  should  be  conducted,  17 
Auditing,  examination  questions,  510 

Auditor,  Liability  of,  with  regard  to  predecessor's  errors,  33 
of  a  bank,  Liability  of,  114 

"    company,  Position  of  an,  26 
on  behalf  of  creditors.  Position  of,  278 
Position  of,  who  disagrees  with  directors,  284 
Qualifications  of  an,  274 
Removal  of,  how  effected,  284 
Responsibility  of,  for  errors,  299 
Right  of,  as  to  resignation,  282 
to  a  firm,  Position  of,  277 
"    an  individual.  Position  of,  276 
Auditor's  duties,  292 

"  duty  as  regards  examination  of  Pass  Books  in  bank  audit,  r  il 

"  "      '*         "       form  of  published  accounts,  206,  239 

*'  "      "         "       individual  partners,  277 

**  "      "         "       secret  reserves,  204 

"  "      "         "       ultra  vires  Acts,  205 

"  "      "         "       valuation  of  stock-in-trade,  1 74 

"  "      "to  verification  of  cash  in  hand,  301 

"  "      "    "    public,  126 

'  "  •'    who  is  refused  permission  to  inspect  Minute  Book,  2o« 

'  "  "   with  regard  to  book  debts,  176 

"  "       "        "  writing  up  of  assets,  204 

"  examination  of  the  books,  Extent  of,  23 

'  "  liability  for  defalcations  of  employees,  290 

"  "         Limits  to,  311 

"  position,  276 

"         responsibility  for  values,  Decision  in  London  and  General  Bank 

case,  173,  358 
' '  right  of  inspection  of  Minute  Book  of  company,  ao i 

"  "     to  his  remuneration,  276 

Auditors,  Amateur,  266 

"  Civil  liability  of,  309 

"  Criminal  liability  of,  307 

"         Distinction  between  various  classes  of,  a66 

"  Duties  of,  285 

"  in  the  13th  Century,  537 

"  Liabilities  of,  290 

"  Liability  of,  for  libel,  305 

"  Methods  of  proceeding  against,  civilly,  309 

"  OflBcial,  271 


INDEX.  571 

Auditors,  position  under  English  Companies  Act,  286 
"  "Privilege"  of,  283,  306 

"  Procedure  by  way  of  action  against,  309 

"  Professional,  269 

Rights  of,  285 
Bad  and  doubtful  debts.  Provision  for,  196 
"       "  "  "      Treatment  of,  77 

"    debts,  Extract  from  Accountant  on  provision  for,  197 
"         "      in  investigations  as  to  profits.  Method  of  dealing  with,  332 
"         "      Methods  of  providing  for,  77 
"         "      Provision  for,  by  percentage  of  sales,  78 
"    figures  in  accoimts,  31 
Balance  Sheet,  Comparison  of  Ledgers  with  previous,  32 
"  "       Consolidated,  239 

"  "       Criticism  of  American,  221 

Forms  of,  217,  411,  427,  430,  436,  454,  459,  463,  484-492 
"  "       Principles  of  compiling  a,  169 

*       "  "       Reason  for  transposing  liabilities  and  assets  in,  2 1 7 

"  "       Responsibility  for  values  in,  173 

"        Sheets  in  investigations,  Necessity  of  inspecting,  327 
Balances,  Necessity  for  checking  starting,  32 
Balancing  books.  Importance  of,  exactly,  46 

"  Methods  of,  46 

Bank   Account,  Method  of  vouching,  40 
"       assets  of,  Method  of  vouching,  114 
"       auditor  of  a.  Liability  of,  114 
"       balance.  Verification  of,  177 
"       borrowers'  statements.  Forms,  409,  495 
"       charges.  Advisability  of  checking,  62 
"       Pass  Book,  English  system  contrasted  with  American,  40 
"  "         "      Ideal  way  of  writing  up,  40 

"  "         "      Method  of  checking,  with  Cash  Book,  40,  122 

"       Points  in  Revenue  Account  of,  119 
"       Reports,  national,  Forms,  404,  455 
Bankers'  credit  information  committee  report,  26 
Banks,  accoimts  of.  Points  in  audit  of,  114 
"        certified  borrowers'  statements  for,  26 
"        Corporation  Tax  Law,  562 
"        methods  of  computing  interest,  342 
Beneficiaries,  Procedure  on  division  of  estate  between,  155 
Bills  of  exchange,  Method  of  vouching,  43 
"      receivable.  Examination  of,  44 
"  "  Verification  of,  179 

Bonds  in  Balance  Sheet,  Treatment  of,  225,  230 
"      Treatment  of,  discount  on,  50 


57^  INDEX. 

Book  debts,  Auditor's  duty  with  regard  to,  176 

"  "      Verification  of,  176 

Bookkeepers,  Instructions  for,  5  7 
Bookkeeping  by  Card  system,  70 
"  Criticism  of  card,  7 1 

"  Double-entry,  Advantages  of,  246 

Loose-Leaf  system  of,  70 
Borrowers'  statements,  Forms,  409,  495 

Branch  Accounts  of  banks,  Extent  of  auditor's  examination  of,  114 
"       establishments.  Accounts  of,  82 

"  Stock  Accotints  in,  84 

Breweries,  accounts  of.  Points  in  audit  of,  96 
Brewery,  audit  of,  Saloons  in  connection  with,  97 

plant.  Depreciation  in  connection  with,  97 
Building  and  Loan  Associations,  Accoimts,  Frauds  in,  161 

Forms,  405,  459 
Points  in  the  audit  of,  161 
Buildings  and  land,  Verification  of,  190 

"        Depreciation  of,  190 
Burleigh,  Herbert  Alfred  v.  Ingram  Clark  Lint,,  Decision  in,  374 
By-Laws,  Necessity  of  perusing,  53 
Calculating  interest,  rules  for,  342 
Calling  back  postings,  29 
Cancellation  of  vouchers,  42 

Capital  and  income  in  Executorship  Accounts,  Apportionment  of,  155 
revenue.  Distinction  between,  85,  109,  136,  142,  144 
"        Examples  of  apportionment  between,  137 
expenditure,  Treatment  of  discounts  on,  61 
'     "      in  Balance  Sheet,  Treatment  of,  230,  247 

"     Stock  accounts,  75 
Capital  Stock  Accounts,  audit  of,  49 
Capitalization  of  preliminary  expenses,  171,  200 
Car  Trust  Bonds,  Treatment  of,  185 
Card  bookkeeping,  70 

Cash  and  trade  discount,  distinction  to  be  made  between,  198 
Book,  Form  of  60 

"      Method  of  checking  Bank  Pass  Book  with,  39 
"      Tabular,  Advantages  of,  60 
businesses,  Accounts  of.  Points  in  audit  of,  94 
in  hand.  Auditor's  duty  as  to  verification  of,  303  , 

Decision,  with  regard  to  verification  of,  373 
"  Verification  of,  178,  303 

receipts,  Method  of  vouching,  34 
Certificate  after  investigation.  Extent  of,  316,  325,  338 
"  of  incorporation,  Necessity  of  perusing,  53 


INDEX.  573 

-Certification,  Extent  of  auditor's,  290 

"  Legislative  requirement,  280 

C.  P.  A.  examination  questions,  510 

Charitable  institutions.  Accounts  of.  Points  in  the  audit  of,  1 58 
Charter,  necessity  of  perusing,  53 
Checking  additions,  32 

Churches,  accoimts  of,  Points  in  the  audit  of,  1 59 
City  accoimts,  Forms,  410,  421,  497 
Civil  liability  of  auditors,  309 
Clerks,  Qualifications  of,  275 
Clubs,  accounts  of.  Points  in  audit  of,  99 
Coal  mines,  accounts  of.  Points  in  audit  of,  109 
Code  of  professional  ethics,  380 

Colleges  and  schools,  accounts  of.  Points  in  the  audit  of,  160 
Columnar  Cash-book,  advantage  of,  60 
Commercial  Law,  examination  questions,  511 
Commission  on  the  underwriting  or  placing  of  shares,  49 

"  profits  from,  Treatment  of,  on  underwriting  shares,  259 

Companies  (English)  Act,  extracts  from,  253,  286 
Comparative  Depreciation  Table,  189 
Comparison  of  Ledgers  with  previous  Balance  Sheet,  32 

"  Revenue  Accounts  in  investigations  as  to  profits,  329 

"Completed  audit,"  Advantages  of  a,  28 

"  "  Disadvantages  of  a,  29 

Confirmation  of  customers'  accounts,  37,  117 
Consignment  Accounts,  81 

Method  of  vouching,  45 
Consolidated  Balance  Sheets  and  Profit  and  Loss  Statements,  239 
"  "  "       A.  Lowes  Dickinson's  opinion  on,  239 

Contingent  assets  in  Balance  Sheet,  229 

"  liabilities  in  Balance  Sheet,  Treatment  of,  238 

"  "         Verification  of,  184 

"Continuous  audit,"  advantages  of  a,  28 
"  "  description  of,  28 

"  "  disadvantages  of  a,  28 

Continuing  Partners,  duties  of,  337 
Contractors,  Accounts  of,  Forms  of,  214 

"  "  Points  in  audit  of,  95 

•Contracts,  Uncompleted,  Valuation  of,  180 
Conversions,  Treatment  of  expenditure  on,  139 
Cooper,  John  A.,  Code  of  Ethics,  380 
-Copyrights,  Depreciation  of,  195 

"  Valuation  of,  106 

Corporation  Accounts,  audit  of,  48 

Tax  Law,  U.  S.  (1909),  540 


574  INDEX. 

Corrections  in  accounts,  31 

Cost  Account  of  shipping  company,  Meaning  of,  151 
**     Accounts,  59 

**  **         Necessity  of  having  proper,  59,  95,  214  ^ 

Coupon  Accounts,  52 
Coupons,  Method  of  filing  cancelled,  52 

Creditors,  Position  of  auditor  on  behalf  of,  278  j 

Criminal  liability  of  auditors,  307 
Criticism  of  American  Balance  Sheets,  221 

*•  Card  Bookkeeping,  70 

Current  assets,  170,  172,  221 
Customers'  accoimts.  Manipulation  of,  35 

'•  "  Verification  of,  37 

"Dating  forward,"  Danger  of,  invoices  for  purchases,  185 
Dead  or  minimum  rents  in  Mining  Accounts,  Definition,  of  no 
Debts,  book,  Auditor's  duty  with  regard  to,  176 
Ledger,  Doubtftil,  Explanation,  of,  78 
"       owing  to  company.  Treatment  of,  in  Balance  Sheet,  223 
Decision  in  American  Malting  case,  251 

'*         "   Appletonv.  American  Malting  Company,  2  $0 

*•         *'   Dovey  and  others  v.  Cory,  348 

'*         "   DumhelVs  Banking  Company,  Lim.,  308  . 

•  *         "  Foster  v.  The  New  Trinidad  Lake  A sphalte  Company,  Lim.  ,249 

*•         "   Herbert  Alfred  Burleigh  v.  Ingram  Clark,  Lim.,  374 

"         **  Lee  V.  Neuchatel  Asphalte  Company,  Lim.,  247 

*•         "   London  and  General  Bank  case  as  to  auditor's  responsibility 

for  values,  173.  3 5^ 
"         '*   London  Oil  Storage  Company,  Lim.,  v.  Seear,  Hasluck  &  Co., 

with  regard  to  verification  of  cash  in  hand,  373 
*•         "   Lubbock  V.  The  British  Bank  of  South  America,  Lim.,  248 

"   Martin  v.  Isitt,  299,  374 
**         *'   Moxham  and  others  v.  Grant,  313 
•'         "   Newton  v.  Birmingham  Small  Arms  Co.,  Lim.,  377 
"         "   Richardson  V.  Buhl,  2 S7 
'*         "   Short  &  Compton  v.  Brackett,  319,  372 
••         "  Smith  V.  Sheard,  376 
"         "    The  Astrachan  Steamship  Company,  Lim.,  and  others  v.  Har- 

mood-Banner  &  Son,  311 
**         *'    The  Edinburgh  United  Breweries,  Lim.,  v.  James  A.  Molleson 

{Nicholson's  Trustee),  317 
*•         "    The  Irish  Woollen  Company,  Lim.,  v.  Tyson,  367 
"         "    The  Kingston  Cotton  Mill  Company,  Lim.,  363 
"         "    The  Leeds  Estate  Building  and  Investment  Society,  Lim.,  v. 

Shephard,  310,  358 
*•         *'   Wilde  and  others  v.  Cape  &  Dalgleish,  299,  367 


INDEX.  575 

Decision  in  Wilmer  v.  McNamara  &  Co.,  Lim.,  248 
Defalcations  of  employees,  Auditor's  liability  for,  299 
Definition,  Buckley's,  of  term  "profits,"  254 
of  depreciation,  187 

minimum  or  dead  rents  in  Mining  Accounts,  110 
term  "assets,"  216 
"     "profits,"  253,  254,  391 
"     "Reserve  Fund,"  228 
vouching,  34 

words  "sale  as  a  going  concern,"  169 
Departmental  Accounts,  94 

Ledger,  67  -*^" 

Depositors'  Pass  Books,  Inspection  of,  117,  120 
Depreciating  assets  in  books  of  accoimt,  Methods  of,  187,  217 
Depreciation  allowed  for  in  Electric  Lighting  Accounts,  Instances  of,  142 
"  and  fluctuation  in  values.  Distinction  between,  171,  187 

"  Annuity  system  of,  190  M 

Definition  of,  187  W 

"  Fund  necessary  where  company  holds  lands  on  lease,  140 

"  in  connection  with  brewery  plant,  97 

"  Instalment  system  of,  190 

"  investigations  as  to  profits,  Method  of  dealing  with,  331 

"  Necessity  of  providing  for,  217 

Depreciation  of  copyrights,  195 
"  buildings,  190 

"  electric  lighting  plant.  Necessity  of  increased,  142 

"  "       Railways,  147 

"  furniture,  194 

"  goodwill,  190 

"  horses,  191 

"  investments,  191 

"  landlord's  fixtures,  196 

"  lands,  189 

leasehold  land  and  premises,  191 
"  leases,  66 

"  licensed  houses,  192 

"  machinery,  192 

*'  .  mines,  112,  193 

"  patents,  194 

"  plant,  194 

"      under  hire-purchase  agreements,  186 
ships,  195 

street  railway  companies,  147 
theatrical  plant,  195 
•  "  Sinking  fimd  system  of,  188 


576  INDEX. 

Depreciation  of  table,  Comparative,  189 
Detection  of  errors  in  books  in  investigations,  317 
"  fraud  as  an  object  of  an  audit,  22 

"  "in  investigations,  322 

Devising  system  of  books.  Points  to  be  considered  in,  55 
Dickinson,  A.  Lowes,  Introduction,  1 1 

Consolidated  Balance  Sheets,  239 
Exhaustion  of  Minerals,  112 
Marketable  Investments,  224 
Sinking  Funds,  229 
Stocks  on  hand,  221 
Dilapidations  to  be  considered  in  depreciation  of  leasehold  premises,  191 
Directors'  fees,  Vouching  of,  199 

Directors,  Position  of  auditor  who  disagrees  with,  285 
Disagreement  of  auditor  with  directors,  285 
Discount  and  interest,  Treatment  of,  50,  61,  342 
Discounts,  Method  of  providing  for  outstanding,  198 
"  on  capital  expenditure,  Treatment  of,  62 

Dividends  or  interest.  Audit  of  payments  for,  51 
"  out  of  capital.  What  is  payment  of,  247 

"  regtilations  respecting  same  in  English  Companies  Act,  253 

"  to  be  paid  only  from  earnings  or  surplus  ,247 

"  Treatment  of  arrears  of  cumulative  preference,  184 

Double  entry  bookkeeping,  Advantages  of,  246 
Doubtful,  and  bad  debts,  Provision  for,  196 
"  "       "        "       Treatment  of,  77 

"         Debts  Ledger,  Explanation  of,  77 
Dovey  v.  Cory,  case  considered,  248 
DumbelVs  Banking  Company,  Lint.,  case  considered,  308 
Duties  of  auditors,  23,  119,  285 

'*  liquidating  and  continuing  partners,  337 

"  official  auditors,  271 

"  principal  at  commencement  of  new  audit,  21 

Edinburgh    United  Breweries,   Lim.,   &c.,   v.   James  A.   Molleson,   case 

considered,  317 
Electric  Light,  Heat  and  Power  Companies,  Forms,  400,  427 
Electric  Lighting  Accounts,  depreciation  allowed  for  in,  142 
"  "  •'         Points  in  audit  of,  141 

"        Railways,  Depreciation  of,  147 
"  "         Forms,  399,  422 

"  "         Points  in  audit  of,  146 

Employees,  defalcations  of,  Auditor's  liability  for,  299 
Errors,  Localizing,  47 

"        Responsibility  of  auditors  for,  307 
Ethics,  Code  of  Professional,  380 


INDEX.  577 

Ethics,  Rules,  384 

Examination  questions,  C.  P.  A.,  510 

Executors  and  trustees,  accounts  of.  Points  in  audit  of,  155 

Executorship  Accounts,  Apportionment  of  capital  and  income  in,  155 

Expenditure  on  conversions,  Treatment  of,  139 

"  "  new  works,  in  place  of  old.  Treatment  of,  137 

Expenses,    Distinction  between  various  classes  of,  260 
"  of  revenue,  260 

"  which  may  be  spread  over  a  number  of  years,  260 

Extent  of  an  auditor's  examination  of  the  books,  23 
"         auditor's  certification,  290 
"         certificate  after  investigation,  316,  324,  337 
"        investigations  as  to  profits,  316 
Fees,  directors'.  Vouching  of,  199 
Figures,  Bad,  in  accoimts,  31 

Finance  companies,  speculative,  accounts  of.  Points  in  audit  of,  126 
Financial  tmdertakings,  accounts  of,  Points  in  audit  of,  114 
Fire  Instirance  Companies,  accounts  of,  Points  in  audit  of,  122 
Firm,  Position  of  auditor  to  a,  277 
Fixed  and  floating  assets,  Distinction  between,  170 
"      assets  in  Balance  Sheet,  Treatment  of,  220 
"  "      Definition  of,  A.  L,  Dickinson,  224 

"  "      Valuation  of,  171,  263 

Fixtures,  landlord's,  Depreciation  of,  196 
Floating  and  fixed  assets,  Distinction  between,  171 
'*        assets  in  Balance  Sheet,  Treatment  of,  221 
"  "       Valuation  of ,  172,  263 

Fluctuation  and  depreciation  in  values,  Distinction  between,'! 71,  187 
•'  in  assets  and  secret  reserves,  203 

"  of  values  in  accounts.  Treatment  of,  187 

Foreign  exchanges,  Treatment  of,  204 
Forfeited  shares,  202 
Form  of  Audit  Note  Book, 
Balance  Sheet,  208 
Cash  Book,  60 

published  accounts.  Auditor's  duty  as  regards,  206,  239 
Revenue  Account  for  traders  considered,  209 
for  Borrowers  from  Banks,  409,  495 
"  Building  and  Loan  Associations,  405,  459 
"  Electric  Light,  Heat  and  Power  Companies,  400,  427 
"  Electric  Railway  Companies,  399,  422 
"  Gas  Companies,  401,  436 
Insurance  Companies,  405,  463 
Mtinicipal  Reports,  410,  421,  497 
"  National  Bank  Reports,  404,  455 


578  INDEX. 

Form    of  Public  Service  Corporations,  399,  421 
"        "  Steam  Railroads,  396,  411 
"        "  Water  Supply  Enterprises,  401,  441 
Forms  of   accounts  for  contractors,  214 

"  "  manufacturers,  212,  407,  484 

"  "  mines,  215 

"  "  traders,  211,  408,  492 

Foster  V.  The  New  Trinidad  Lake  Asphalte  Co.,  Ltd.,  decision,  249 
Fraud,  Audit  not  an  insurance  against,  271 

"        Detection  of,  as  an  object  of  an  audit,  22 
"        in  investigations,  Detection  of,  322 
Fraudulent  alterations  during  audit,  Methods  of  detecting,  43 
Funds,  meaning  of  word,  232 
Furniture,  Depreciation  of,  194 

Future  Deliveries,  dangers  of  anticipating  profits  on,  181 
Gas  companies,  accounts  of,  Points  in  audit  of,  139 

"  "  Forms,  401,  436 

General  accounting,  examination  questions,  511 
Gold  Mines,  &c.,  accounts  of,  Points  in  Audit  of,  112 
Goodwill,  Depreciation  of,  190 

"         in  accounts.  Treatment  of,  190 
"         Meaning  of,  in  Balance  Sheet,  190 
Governmental  supervision,  273 
Gross  Profit,  Meaning  of  term,  211 

"       use  in  checking  stock  accounts,  71 
Heat  and  Power  Companies,  Forms,  400,  427 
Hire-purchase  agreements,  185 

"  "  Depreciation  of  plant  under,  194 

Holding  Companies,  Consolidated  Balance  Sheets  in  connection  with,  241 
Horses,  Depreciation  of,  191 
Hospitals,  Points  in  audit  of,  158 
Hotels,  accounts  of,  Points  in  audit  of,  98 

Hutchinson  &  McElheny  v.  American  Malting  Co.,  decision,  386 
Imprest  system  of  petty  cash,  56,  62 

Income  and  capital.  Apportionment  of,  in  Executorship  Accounts,  155 
Individual,  Position  of  auditor  to  an,  276 
Inspection  of   Minute  Book,  201 
securities,  117,  162 
Instalment  system  of  depreciation,  188 
Instructions  as  to  general  system  of  accounts,  57 
"  preparation  for  audit,  88 
"  for  audit,  17,  20 

Insurance  Company,  Amount  of  reserve  necessary  for,  121 
"  Companies,  accounts  of,  Points  in  audit  of,  121 
"  "  Corporation  Tax  Law,  561 


INDEX.  579 

Insurance  Companies,  Life,  Forms,  405,  463 

"         funds  in  shipping  companies,  Limitations  of,  150 
Interest  and  discount.  Treatment  of,  61 
"         Calculation  of,  342 

"         or  dividends.  Audit  of  payments  for,  51 
"         Rules  governing,  355 
Internal  check,  system  of.  Essential  points  in,  56 
Interstate  Commerce  Commission,  powers  of,  133 
Investigation,  Extent  of  certificate  after,  317,  324,  337 
Length  of  period  to  be  covered  by,  325 
Limits  of  an,  321 
"  Method  of  procedure  in  an,  325 

"  on  behalf  of  a  projected  company,  320 

Investigations  as  to  profits,  Adjustments  of  profits  in,  332 

"  "  "        Comparison  of  Revenue  Accounts  in,  327 

"  "  "        Examination  of  Revenue  Accounts  in,  327 

"  "  "        Exceptional  losses  and  profits  in,  334 

"  "  "        Extent  of,  316 

"  "  "        General  course  of  procedure  in  an,  327 

"  "  "        Inspecting  Balance  Sheets  in,  327 

"        Method  of  dealing  with  bad  debts  in,  331 
"  "  "        Method  of  dealing  with  depreciation  in,  331 

"  Detection  of    errors  in  books  in,  317 

"    fraud  in,  322 
"  Opinion  of  accountants  on  extent  of,  319 

**  Purposes  for  which,  are  made,  315 

Investment  Companies,  Accounts  of.  Points  in  audit  of,  124 
"  Fluctuation  Accounts,  Meaning  of,  232 

"  of  Reserve  Funds,  236 

Investments,  Depreciation  of,  191 

"  in  Balance  Sheet,  Treatment  of,  223 

"  "  stocks  and  shares.  Verification  of,  175 

"  Valuation  of,  in  audit  of  Investment  Companies,  126 

Invoices  for  purchases.  Danger  of  "dating-forward,"  183 
Irish  Woollen  Company,  Lim.,  case  considered,  300,  367 
Journal,  Method  of  vouching,  42 

Use  of  the,  41,  79 
Kingston  Cotton  Mills,  case  considered,  295,  363 
Land  and  buildings,  Verification  of,  174 
Landlord's  fixtures,  Depreciation  of,  196 
Lands,   Depreciation  of,  189 

"        on  lease.  Depreciation  Fiind  necessary,  191 
Lawyers,  Accoxmts  of.  Points  in  audit  of,  164 
Leasehold  land  and  premises.  Depreciation  of,  191 
Leases,  Depreciation  of,  66 


580  INDEX. 

Ledger,  Advantages  of  making  each  self -balancing,  66 
"       doubtful  debts,  Explanation  of,  77 
"       Tabulation  of  the,  48 
Ledgers,  Accounts  for  which  Tabular,  are  suitable,  67 

Comparison  of,  with  previous  Balance  Sheet,  32 
Purchase,  of  retailer.  Audit  of,  93 
Sales,  of  retailer,  Audit  of,  92 
Self -balancing,  47,  57,  66,  83 
Tabular,  68 

Lee  V.  Neuchatel  Asphalte  Company,  Lint.,  case  considered,  247 
Leeds  Estate  Building  and  Investment  Society  v.  Shephard  case  considered, 

310.  358 
Legislative  requirements,  280,  296 
Length  of  period  to  be  covered  by  investigation,  325 
Liabilities  and  assets  in  Balance  Sheet,  reason  for  transposing,  217 
Contingent,  Verification  of,  184 
in  Balance  Sheet,  Treatment  of  contingent,  238 
"  "  "  "  general,  226 

"  of  auditors,  27,  290 

"  outstanding.  Verification  of,  183,  230 

Liability,  auditors  for  libel,  305 

"        Civil,  of  auditors,  309,  356 

"        Criminal,  of  auditors,  307 

"        Insurance  Companies,  Accounts  of,  125 

of  auditor  of  a  bank,  114 
"  "         with  regard  to  predecessor's  errors,  33 

Libel,  Liability  of  auditor  for,  305 

Life  Insurance  Companies,  accounts  of,  Points  in  audit  of,  124,  225 
"  "  "  Forms,  405,  463 

"  "  "  Reserve  fund  of,  232 

Limitations  of  audit,  272 

"  Tabular  Ledgers,  68 

Limits  of  an  investigation,  321 
"     to  auditor's  liability,  312 
Liquidating  Partners,  Duties  of,  337 
List  of  books,  preparation  of,  24 

"         statistical  books  which  companies  should  keep,  52 
Localization  of  errors  in  Trial  Balance,  47,  79 
London  and  General  Bank  case  as  to  auditor's  responsibility  for  values. 

Decision  in,  173,  293,  358 
London  Oil  Storage  Co.,  Lim.,  v.  Seear,  Hasltick  &  Co.,  with  regard  to 

verification  of  cash  in  hand,  Decision  in,  303,  373 
Loose-Leaf  System  of  bookkeeping,  70 

Lubbock  V.  British  Bank  of  South  Africa,  Lim.,  case  considered,  248 
Machinery  and  plant.  Verification  of,  177 


INDEX.  581 

Machinery,  Depreciation  of,  192 
Magazines,  accounts  of,  Points  in  audit  of,  107 
Manufacturers,  accounts  of.  Forms  of,  212,  407,  484 
Manufacturing  and  trading  profits.  Distinction  between,  172 
"  Corporations,  Corporation  Tax  Law,  565 

*'  traders,  accounts  of.  Points  in  audit  of,  92 

Martin  v.  Isitt,  case  considered,  299,  374 
Mechanical  bookkeeping,  40f  84 

Medical  men,  accounts  of.  Points  in  the  audit  of,  166 
Mercantile  Corporations,  Corporation  Tax  Law,  562 

"  Enterprises,  Forms,  407,  484 

Merchants,  Wholesale,  accoimts  of.  Points  in  audit  of,  91 
Meter  rents,  Method  of  vouching  income  from  gas  rates  and,  140 
Mines,  accotints  of.  Forms  of,  215 

"  "  Points  in  audit  of,  109 

"       Depreciation  of,  no,  193 
Mining  Accounts,  Definition  of  minimum  or  dead  rents  in,  109 
Minute  Book,  Auditor's  duty,  who  is  refused  permission  to  inspect,  201 
"  "      Inspection  of,  53,  201 

"  "      Liabilities  recorded  therein,  184 

"  "      of  company.  Auditor's  right  of  inspection  of,  201 

Montgomery,  Robert  H.,  Accounts  of  Public  Service  Corporations,  134 

"  "  Accounts  of  New  York  City,  154 

Mortgages,  Treatment  of,  in  Balance  Sheets,  227,  231 
Moxham  v.  Grant  case  considered,  313 
Municipal  accotmts,  152 

"         ownership,  132,  152 
"         reports,  Forms,  410,  421,  497 
National  Banks  Reports,  404,  455 
"Net  Profit"  and  "Profit  safely  divisible,"  distinction  between,  264 

"        "        meaning  of  term,  216,  252 
Newspapers,  accounts  of.  Points  in  audit  of,  107 
Newton  v.  Birmingham  Small  Arms  Co.  decision,  377 
New  works  in  place  of  old.  Treatment  of  expenditure  on,  137 
Nicholson's,  Trustee,  &c.,  case,  317 
Notes  payable.  Vouching  of,  44 

"      promissory.  Calculation  of  interest  on,  342 
"      receivable.  Vouching  of,  44 
Object  and  scope  of  an  audit,  22 
"      of  investigations,  3 1 5 

Revenue  Accounts,  209 
Official  auditors.  Duties  of,  271 

Opinion  of  accoimtants  on  extent  of  investigations,  319 
Outstanding  Assets,  182 

discounts,  198 


582  INDEX. 

Outstanding  liabilities,  183 

Partners,  Auditor's  duty  as  regards  individual,  277 

"  retiring,  Duties  to,  338 

Partnership  agreement,  Points  to  be  considered  in  drawing  up,  85 

"  agreements,  85 

Pass  Books  in  bank  audit,  Examination  of ,  1 1 6 
Patents,  Depreciation  of,  194 

Payment  of  dividends  out  of  capital,  What  is,  248 
Payments  for  dividends  or  interest,  Audit  of,  51 
Pennsylvania  C.  P.  A.  questions,  513 

"  Legislature,  Bill  introduced  in  1905  session,  280 

Percentage  of  profits,  Method  of  calculating,  73 
Periodicals,  Accounts  of.  Points  in  audit  of,  107 
Petty  Cash  Book,  Method  of  keeping,  38,  62 

"        "       Imprest  system  of,  57,  63 
.    "        "       Method  of  vouching,  38,  94 
"       payments,  Treatment  of,  63 
Plant  and  machinery.  Verification  of,  177 

"      brewery.  Depreciation  in  connection  with,  96 
"      Depreciation  of,  194 

"      Necessity  of  increased  depreciation  of  electric  lighting,  142 
"      theatrical,  Depreciation  of,  195 
Postings,  Calling  back,  29 
Powei  Companies,  Forms,  400,  427 
Preliminary  expenses,  Capitalization  of,  172,  200 

"  "  in  accounts.  Treatment  of,  104,  200,  264 

"  "  Vouching  of,  200 

Premium  income  of  insurance  office.  Method  of  vouching,  123 
Premiums  received  on  issue  of  shares.  Treatment  of,  49,  202 
Preparation  for  audit,  Instruction  as  to,  88 
Previous  Balance  Sheets,  Treatment  of,  32 
Principal,  Duties  of,  at  commencement  of  new  audit,  2 1 
Principles  in  valuation  of  assets,  169 

of  compiling  a  Balance  Sheet,  168 
of  valuing  work  in  progress,  179 
"Privilege"  of  auditor,  306 
Procedure  by  way  of  action  against  auditors,  310 

"  on  division  of  estate  between  beneficiaries,  155 

Professional  auditors,    269 

*'  "  number  in  United  States,  269 

"  ethics,  380 

Profit  and  Loss  Account,  consolidated,  239 

**       safely  divisible  and  "Net  profit,"  Distinction  between,  264 
Profits  available  for  dividend,  386 
"        Definition  of  term,  254,  255 


INDEX.  583 

Profits  Distinction  between  various  classes  of,  258 
Extent  of  investigations  as  to,  316 

from  commission  on  underwriting  shares,  Treatment  of,  259 
in  investigations  as  to  profits,  Adjustments  of,  332 
Method  of  calculating  percentage  of,  73 
of  Public  Service  Corporation,  paper  on,  134 
on  sales  of  investments,  Treatment  of,  127 
Testing  if,  are  safely  divisible,  264 
Promissory  Notes,  44 

Prospectus  of  company,  N"ecessity  of  perusing,  53 
Provision  for  bad  and  doubtful  debts,  196 

"  "       debts  by  percentage  of  sales,  77 

Public  Authorities,  Accounts  of,  Points  in  audit  of,  152 

"      Service  Corporations,  Accounts  of,  Points  in  audit  of,  132,  134,15* 
"  "  "  Corporation  Tax  Law,  563 

"  "  "  Forms,  399,  421 

"  "  "  Report  on,  Paper  of  R.  H.  Montgomery,  read 

at  St.  Louis  Congress  of  Accountants,  134 
Published  accounts,  form  of,  Auditor's  duty  as  regards,  206,  239 
Publishers,  accounts  of,  Points  in  audit  of,  105 
Purchase  Ledger  of  retailer,  Audit  of,  92 
Purchases,  Danger  of  ' '  dating  forward ' '  invoices  for,  183 

"  Method  of  recording,  58 

Qualifications  of  an  auditor,  274 

"  audit  clerks,  275 

Questions  C.  P.  A.,  510 
Quick  Assets,  221 

Railways,  Steam,  accounts  of,  Points  in  audit  of,  143 
"         Street,    accoimts  of.  Points  in  audit  of,  145 
Receipts  of  revenue,  258 

Redeemable  stocks  and  bonds.  Treatment  of,  202 
Removal  of  auditor,  how  effected,  284 
Remimeration,  Auditor's  right  to  his,  276 
Rent  roll.  Necessity  of  keeping  proper,  64 
Rents  received  and  paid,  Method  of  treating  in  accounts,  64 
Reserve,  Amount  of,  necessary  for  insurance  company,  123,  235 

for  depreciation  and  Reserve  Fund,  Distinction  between,  217,  263 
Fund,  2c^,  232 

"      Definition  of  term,  232 

in  Balance  Sheet,  Method  of  stating,  232 
"      Investment  of,  236 
Reserves,  regulation  respecting  same  in  English  Companies  Act,  253 
"         secret.  Auditor's  duty  as  regards,  204 
"         Treatment  of,  A.  L.  Dickinson  on,  229 
Resignation,  Right  of  auditor  as  to,  282 


'584  INDEX. 

Responsibility  for  values  in  Balance  Sheet,  173 

"  of  auditor  for  errors,  307 

Restaurants,  accounts  of,  Points  in  audit  of,  99 
Retailers,  accounts  of.  Points  in  audit  of,  92 
Revenue  account  for  traders.  Form  of,  considered,  211,  408,  494 
"        of  bank.  Points  in,  119 
accounts    in  investigations  as  to  profits.  Comparison  of,  32  7 

"  Object  of,  209 

and  capital,  Distinction  between,  85,  109,  148,  386 
expenses,  260 
receipts,  258 
Richardson  v.  Buhl  decision,  257 
Rights  of  auditors,  285 
Salaries,  Method  of  recording,  80 
Sale  of  an  undertaking  to  continuing  partner,  337 
"    as  a  going  concern.  Definition  of  words,  169 
Sales  for  future  delivery.   Treatment  of,  181,  386 
"        "        "  "  Verification  of,  181 

Ledgers  of  retailer.  Audit  of,  92 
"      of  investments.  Treatment  of  profits  on,  127 
Saloons  in  connection  with  audit  of  brewery,  97 
Savings  Banks,  audit  of,  120 

Schools  and  colleges,  accounts  of.  Points  in  audit  of,  160 
Scope  of  an  audit,  object  and,  22 
Secret  Reserves  and  assets,  Fluctuations  in,  203 
Securities,  Inspection  of ,  1 1 7,  154 
Self -balancing  Ledgers,  47,  57,  58,  66,  83 
Share  Capital  Accotmts,  Audit  of,  48 
Shipping  companies,  accounts  of.  Points  in  audit  of,  150 
Ships,  Depreciation  of,  150,  152,  195 
Short  &  Compton  v.  Brackett,  Decision  in,  319,  372 
Sinking  Fund,  Explanation  of,  233 
"  "      in  mining  account,  no 

"      system  of  depreciation,  189 
"  "      torepay  loans,  Distinction  between,  and  depreciation,  233 

Smith  V.  Sheard,  Decision,  376 

Societies,  building  and  loan,  accounts  of.  Points  in  audit  of,  161 
Speculative  finance  companies,  accounts  of,  Points  in  audit  of,  126 
Sprague,  Chas.  E.,  annuity  tables,  &c.,  189 
Staff,  System  of  work  of,  55 
Statistical  books,  List  of,  which  companies  should  keep,  52 

"  information,  Advantages  of,  215 

Steam  Railways,  accounts  of.  Points  in  audit  of,  143 

"         Forms,  396,  411 
Sterrett  Jos.  E.  Professional  Ethics,  380 


INDEX.  585 

Stock  Accounts,  Advantages  of  keeping  proper,  71,  73,  74 
*'  "         in  branch  establishments,  84 

"  "  Method  of  keeping,  7 1 

"      and  Bonds  Redeemable,  Treatment  of,  202 
"      and  Share  Accounts  of  companies,  75 
Stockbrokers,  accoimts  of.  Points  in  audit  of,  129 
Stock-in-trade,  Auditor's  duty  as  regards  valuation  of,  174,  221 
Stocks  and  shares,  investments  in,  Verification  of,  175 
Stores  and  Stock  accoimts.  Points  in  the  audit  of,  7 1 
Street  Railways,  accoimts  of.  Points  in  audit  of,  145 
Suspense  Accounts,  76 

System  of  books,  Points  to  be  considered  in  devising,  55 
"         "  bookkeeping,  necessity  of  mastering,  24 

"  work  of  staff,  55 
"         on  which  an  audit  should  be  conducted,  17 
Tabular  Cash  Book,  Advantages  of,  60 

Ledgers,  68 
Tabulation  of  the  Ledger,  47 
Theatres,  accounts  of.  Points  in  audit  of,  loi 
Theatrical  Companies,  accounts  of.  Points  in  audit  of,  103 

plant.  Depreciation  of,  195 
Title  Guarantee  Insurance  Companies,  accounts  of,  125 
Trade  and  cash  discoimts.  Distinction  to  be  made  between,  198 
Traders,  accounts  of.  Forms  of,  211,  407,  484 
"  "         "     Points  in  audit  of,  73 

"  manufacturing,  accounts  of.  Points  in  audit  of,  92 

Stock  Accoimts,  73 
Trading  and  manufacturing  profits.  Distinction  between,  172 
Transportation  Corporations,  Corporation  Tax  Law,  563 
"Tretyce  off  Housebandry,"  Extracts  from,  440 
Trial  Balance,  Importance  of  retaining  books  until,  is  audited,  45 

"  Localization  of  errors  in,  47,  79 

Trust  Companies,  essential  points  in  audit  of,  121 
Ultra  vires  acts,  Auditor's  duty  as  regards,  205 
Uncompleted  contracts.  Valuation  of,  182 
Underwriting  or  placing  of  shares.  Commission  on  the,  49 

"  shares,  Treatment  of  profits  from  Commission  on,  259 

Usury,  345 

Valuation  of  assets,  Principles  in,  169,  225 
copyrights,  105 
current  assets,  172,  211,  262 
fixed  assets,  171,  263 

investments  in  audit  of  investment  companies,  126 
marketable  investments,  224 
uncompleted  contracts,  182 


586  INDEX. 

Values  in  Balance  Sheet,  Responsibility  for,  173 
Vouchers,  Cancellation  of,  42 

"  Definition  of,  34 

"  Examination  of,  34 

Wa:es,  Frauds  in,  39 

"       Method  of  vouching,  39 
Water  companies,  accounts  of.  Points  in  audit  of,  141 

"     Supply  Enterprises,  Forms,  401,  441 
Weiner  v.  Wurtemburg  Electro  Plate    Company   and  another,  case  con- 
sidered, 306 
Wholesale  merchants,  accounts  of.  Points  in  audit  of,  91 
Wilde  and  others  v.  Cape  and  Dalgleish,  Decision  in,  299,  367 
Wilkinson,  George,  Audit  of  insurance  companies,  124 
Wilmer  v.  McNamara  &  Co.,  Lim.,  248 
Work  in  progress,  Verification  of,  179 


OF  THE 

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OF 


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thVs  book  on  the  date  DUE^  ^^^^^„ 

^TlI  INCREASE  TO  50^^ENTS^0^^^^^^     ^^^ 

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202587 


